There is nothing that highlights more the uphill struggle faced by libertarians than an old joke which is directed at the economics profession in general:

How many economists does it take to change a lightbulb? None – the market will take care of it.

Unlike our statist counterparts, as proponents of the free market we have no precise design for the solutions of particular issues and problems. We do not have an energy plan, a transport plan, a housing plan or a healthcare plan. Rather, we believe that freely acting individuals, endowed with private property rights, will find the solutions that utilise the scarce resources that we have in the most efficient way possible. Indeed, when asked the (almost tiresome) question “who will build the roads?” we don’t, strictly, know that a free market will produce any roads whatsoever. There may, in fact, be some better transport solution that compulsory government road funding prevents us from discovering. This is, in fact, the entire point of the free market – that there is no grand, overarching plan with particular solutions that are imposed upon everyone else from on high. Moreover, any kind of centralised plan or desire for the government control of goods and services has always presupposed the existence of industries and products, such as roads, that were invented by freely acting individuals.

This key aspect of the free market – a complete lack of centralised design of products, services and entire industries – is not limited to the substantive configuration of resources. Rather, as we shall attempt to argue at length in this two-part series of essays, it extends also to the very concepts and institutions that uphold a free market order – in particular, laws, rights, property, non-aggression. Part of the question we wish to explore here, then, is if we, today, had to the opportunity to sweep aside the entire mantra of statist oppression, would the institutions that we put in its place be subject to some kind of design by libertarians or would they also be subject to some kind of decentralised action by freely acting individuals? In other words, would we come along and say “this individual has rights”; “this object is property”; “this act is aggression”? More potently, however, we need to explore whether the nature and origin of concepts such as rights, property, aggression, and conflicts lend themselves to some kind of conscious design or whether they depend upon the behaviour of freely acting individuals in order for their true meaning to be realised. Once we have determined this we will be able to conclude whether it is only by recognising the dependence of these concepts upon freely acting individuals that a genuine libertarian society be built.

Some readers will recognise that we are following here a line of epistemological thinking propounded by F A Hayek, mostly in Law, Legislation and Liberty, as to the appropriate use of rationalism in understanding and framing societal institutions – i.e., is our rationality, our ability to reason and to act purposefully, better suited to constructing and designing social institutions, or rather, are these institutions instead the product of some kind of “spontaneous order”? If the answer is the latter then the focus of our rational endeavours should be to gain comprehension, insight and understanding into elements of human interaction that have already been built and not to recreate these elements anew.

Let us begin with some simple examples in order to illustrate what we mean by this. The first example we shall use is language. Any language that we speak is a complicated thing, with lots of different words and lots of different rules for using those words. However, language itself and the very vast majority of specific languages were not invented explicitly by anyone. Rather, they grew up through millennia as a result of individual people striving to communicate ideas to each other. The meanings of words but also the concepts of sentences and grammar also developed without any centralised plan and before anyone acknowledged consciously the precise forms and structures they were using. For example, if, years ago, one of the first humans said “I will throw this ball”, neither he nor his partners in dialogue would have known explicitly that he was using a subject, a verb and an object to create what we now call a sentence. If he elaborated and said “I will throw this red ball” he would not have known that he just inserted what we now call an adjective. Yet anyone he spoke to would have understood the ideas that he was trying to communicate in the sentence. Moreover, if he tried to say something like “ball thrown I red” those listening to him would probably recognise that he was talking utter nonsense – but they would not necessarily be able to say precisely why this sentence is wrong. Indeed, even the idea behind concepts such and nouns and verbs probably never even entered these people’s minds – in the same way that they do not explicitly enter the minds of the vast majority of people who communicate through language today. It was only after many centuries of languages being used and developed that linguists came along in order to study the phenomenon of language systematically and to develop the rules and concepts of grammar, writing and speech. Yet, crucially, the role of the linguist or grammarian was not to invent or design these rules, or to reconfigure language as a whole. Rather, his role was to gain insight and understanding into a process that already existed – to gain rational comprehension of a phenomenon that was of no single human’s construction. For example, an adjective is a particular concept that concerns the use of words in order to describe nouns. For example, a red ball; a tall boy; an old lady. By calling these words adjectives the linguist did not invent the concept of an adjective. Rather, the concept itself already existed as a phenomenon of human interaction for which the linguist only provided a label for us to identify it and distinguish it from other phenomena. Thus the label “adjective” aids the endeavour of gaining rational insight and understanding into the phenomenon of language and does not amount to the construction of anything that was not already there. If, on the other hand, linguists tried to reinvent these concepts or to attempt to apply them to other phenomena then we can see easily that we would run into all sorts of trouble. Let us imagine that a budding, pioneering linguist comes along with the aim to reinvent the rules of language, to undergo a reconstruction in order make it more coherent and, no doubt, more “rational”. After all, he is a scientist of the human race, a race that has managed to build everything from enormous craft that fly into space all the way down to tiny computers that fit into your hand. Surely he can master the design of something as simple as how we speak to one another? Let us say that he decrees that an adjective should describe not the noun in a sentence but, rather, the verb. So in the sentence “I will throw this red ball” this linguist would claim that the word “red” should actually describe the verb “throw” – so that the quality of throwing is, in some way, red. Or in the sentence “I will drink this hot coffee” the word “hot” describes the act of drinking rather than the condition of the coffee. Clearly such a reinvention would lead to utter nonsense and a complete breakdown of the purpose of language, which is the successful communication of an idea, i.e. making yourself understood by another party. The concepts that the linguist identifies, such as adjectives, are not open to his reconstruction – to him they are phenomena that already exist as a given, much like the fact that the sun rises and water flows down. The only difference is that the phenomena associated with language arose out of the interaction of many millions of human beings across centuries rather than straight out of the natural world. These concepts the linguist identifies describe a strand of reality that are already there for him to identify and to understand; any attempt by him to impose an alternative meaning or definition of these concepts results in something completely different from their original nature.

Whether or not alternative languages can, in fact, be designed, is beside the point. Languages have been designed explicitly, with Esperanto being the most notable, although any designed language has failed to gain any significant use. Our point here, however, is that existing languages are not the product of design or reinvention and that the concepts we use to identify and understand them are also not invented phenomena. Our attempt to engage in such a reinvention must necessarily result in something completely different from that which already exists.

In order to explore this further let us take another example of a social phenomenon such as prices. Indeed, prices are a classic example of a social institution that, unlike language, has been subject to a kind of constructivist reinvention. The phenomenon of prices appeared as a result of millions of private, bilateral transactions millennia before anyone actually stopped to determine what prices actually were and how individual prices are set at the levels they are. Just as the linguist used his capacity for rational analysis to determine the elements of language, so do did the economist approach the concept of prices with the desire to comprehend and gains insights into this reality, not to construct anything new (an endeavour which was only accomplished sufficiently after the realisation of the law of marginal utility). What was learnt was that a price is the exchange ratio between two goods that results from the competing valuations of those who supply a good versus those who demand it with another good (usually money). The specific price is set between the valuations of the marginal buyer and the marginal seller. The effect of a price at this level was that the willing supply and willing demand for a good were equalised.

What happens, however, when we deflect our rational thinking away from gaining comprehension of this phenomenon and embrace, instead, the desire to gain control of and “create” or (as economists usually say) “fix” prices? This false, constructivist approach looked only at surface level phenomena of prices that were manifest in the fact that the act of pricing was largely carried out by entities that were sellers of commodities and buyers of labour – in other words, businesses. This, aided by other confusions such as the paradox of value – the conundrum as to why a diamond costs more than water when the latter is infinitely more useful to mankind – led to the conclusion that prices were simply declared (as opposed to estimated) by sellers and/or were merely the arbitrary and capricious results of unrestrained greed. It would follow from these falsehoods that the price of a good could be manipulated at will or established by decree. Yet it is clear that this conception of prices has entirely different ramifications from the previous one that we outlined. With these new, constructed prices their ultimate influence is not the individual interactions of all of the millions of people attempting to fulfil their purposes but rather the preoccupations of those who decree them (i.e. the state), which are mainly political. Most of the famous cases of price fixing were designed to counteract the effects of rampant inflationism, such as the Emperor Diocletian’s fourth century Edict on Maximum Prices and President Nixon’s price and wage controls in the 1970s. The results of these prices too are markedly – even catastrophically – different. If the decreed price is too high relative to the price that would be set by supply and demand then an unsold surplus of the good would accumulate; if the price was too low then a chronic shortage would ensue. In both cases the quantity demanded and the quantity supplied are shifted out of balance, resulting in economic turmoil – as it was in the 1970s when Nixon’s price controls exacerbated the effects of the OAPEC oil embargo, leading to an acute shortage of gasoline (which, of course, promoted further government intervention in the form of selective government rationing, the 55mph speed limit and the moral degradation that occurs as a result of the destruction of the supplier/customer relationship).

Under both conceptions of prices – the un-designed and the designed – all of the surface phenomena of prices are constant. Price tags are still on the goods (if there are any goods) and money still changes hands. Yet it is clear that the difference between the two concepts is to encapsulate two entirely different strands of reality that each have vastly different origins and motivations, and vastly different consequences. In moving from the first conception to the latter, the concept of price has been changed from meaning the exchange ratio that results from the interaction of supply and demand to basically meaning the exchange ratio that is ordered by the state.

It is clear from this, therefore, that a concept, such and nouns, verbs, prices, which developed as a result of human interaction, cannot simply be changed at will or by agreement without entirely undermining its essence. Indeed with prices not even an explicit agreement amongst all of the consenting citizenry as to what a particular price should be would circumvent this fact because the resulting exchange ratio would still not accord with the reality that the concept of price tries to capture, which is the exchange ratio that results from supply and demand. What we can also begin to see is that any attempt to redesign or reconstruct these phenomena destroys their service for free, individual people and instead places them at the service of the state and is therefore antithetical to liberty. We can see this more clearly in a third example of this type of concept which is money itself. The phenomenon of money – the generally accepted medium exchange – appeared through millions of bilateral exchanges before anyone stopped to think about precisely what they were doing when they handed over, say, lumps of metal like gold or silver in exchange for stuff they could eat or use as shelter. Money was something created as a result of human interaction but nobody designed or invented money. The product of this was a medium of exchange that served reliably as a store of value, as a unit of account and as a major bulwark of sustainable economic progress. All of the monetary issues we experience today – the business cycle, inflation, and a grossly unstable financial system – stem from the attempt to recreate the concept of money as something that is created and enforced by the state, an endeavour that has not only resulted in the catastrophic effects we just outlined but also a tremendous loss of liberty as governments have been able to fund their bloated operations without resort to regular taxation.

Bearing all of this in mind, then, what is the nature of other sociological concepts which form the core of libertarian theory? These are concepts such as property, rights, obligations, laws, conflicts, and aggression. Are these phenomena which appeared gradually over many hundreds of years through social interaction? Or were they the explicitly designed product of, say, a wise and benevolent ruler who sought to create order out of chaos? We shall argue here that concepts such as rights and obligations are indeed of the same ilk as prices – they appeared over millennia as a result of millions of humans attempting to fulfil their individual purposes. The concepts were not the product of explicit, human construction; rather, they were a reality that already existed before anyone consciously thought of the matter. The purpose of our rationality is to reflect upon this reality, understand and comprehend what was occurring, and from this understanding fashion these concepts in order to explain and describe this reality. Any attempt to reconstruct them anew will, as we shall see, destroy their real value to the freely acting individual and instead place them in the service of the state.

Let us recall that the question of rights and property only arise because of conflicts that result from scarcity – the fact that two or more individuals cannot satisfy their ends owing to shortage of means. Rights and obligations over physical matter that is designated as “property” are the solution to these conflicts. In other words, rights and obligations only arose because individual, rationally acting beings, incurred a reciprocal recognition in a particular situation that physical means available were not sufficient to satisfy the ends of each, hence one had to yield and refrain from action and the other could act. The source of a conflict was the fact that one of the parties would have to suffer a loss of *value* – and end worse than the one he sought – if he had to yield to the other party, who, in turn, would have his value realised. These conflicts and their prescribed resolutions are endemic to the situation of humans as social animals. It is highly unlikely that two humans ever interacted without running into some kind of conflict over scarce means, particularly as primitive man suffered from the scarcity of the most basic of needs far more than we do today. Hence social rules are likely to be as old as humans themselves. These conflicts and their resolution through a system of rules began long before anyone actually explicitly enunciated that which was occurring. Indeed the words “rights”, “ownership” and what they were may not even have been known to anyone who sought them, in much as the same way as no one knew what a verb or a noun are until long after people actually began to communicate through language. Nobody at any point woke up one morning and said ‘Gosh, I believe it would be awfully nice if everyone had the right to private property!” as if it was an entirely new creation, nor did anyone ever explicitly “agree” the same thing. The earliest rules were probably acknowledged and understood tacitly with communication through body language. Later, as the earliest civilisations were born, customary legal systems developed through appeals by the conflicting parties for adjudication by a plurality. They made this appeal because, in the long run (and according to their own valuations), ad hoc conciliation is uncertain while resolution by violence is both uncertain and costly and dangerous. Indeed, we might say that although this process requires a degree of reflective ability of the plurality’s members, the legal rules and principles that crystallised depended upon a) their ability to address the situation that identified by the rational actors to which they need to be applied, b) the willingness of the parties to yield to them and thus avoid violence, and c) their ability to serve as a guide to behaviour in order to avoid similar incursions in the future. Crucially, there was no centralised force that had the authority to either decree or enforce the law, such authority, where it existed, resulting from usurpation. Rather, adjudicators had to earn and maintain their reputation in the knowledge that parties could seek justice elsewhere and that they – the adjudicators – might too, one day, be involved a conflict and stand to be judged. To this extent, therefore, the dispensation of impartial and principled justice resulted from self-interest. Indeed, we might say that the whole edifice of consistently and impartially applied legal rules existed solely because, in the long run, these things were the cheapest option for people to fulfil their ends. In other words, that agreeing to resolve conflicts peacefully through a system of rules was, in the long run, the best way for people to maximise their wellbeing. The result of this was, of course, the development of society – the peaceful co-operation between individuals seeking to fulfil their needs and better their lives.

Indeed, it is important to stress that a well ordered and functioning society was the product of customary social rules and was not their precursor – the peaceful resolution and avoidance of conflicts is what permits social co-operation, either primitively or under the division of labour, to flourish, and it only did so because people desired it. “Society” did not come first in order to fashion and enforce the law or to determine what conflicts were and where they existed and how everybody should behave. We are tempted to address this chicken and egg problem differently today because “society” precedes us and so we also think that it precedes our rights and obligations; we were born into an existing social order that seems to grant and impose these things on us from on high. It certainly true that latecomers to a social order, who, like us, were born in succeeding generations or were formerly outsiders, were likely to find themselves bound by previously enunciated rules. However, the origin of those rules was the perception of conflicts by individual, rationally acting people. So when, today, for example, we extrapolate from these past cases and say that a particular right applies to me and to everyone else in the world it is true that these rules and concepts predated anyone who is alive today so that it appears as though somebody else is either granting us these rights or enforcing these obligations upon us. But even today we can see that rights, obligations and conflicts must originate from the minds of the parties to the dispute that the legal rule seeks to solve. Strictly speaking when we say that “I have the right to private property” what I am really saying is that this right would be enjoyed by me in a hypothetical case where I enter a conflict over a particular good. But just as in the pre-historic cases that crystallised the concept of a right, this conflict would have to be perceived by me in order to be a breach of my rights. Someone taking my property is not theft unless I do not want them to take it; if I am perfectly fine with it then my right is not infringed (indeed, in a world where everyone helped themselves to each other’s stuff as they pleased and everyone had no problem with it no one would even know what a right to private property was). Rape is only rape because a woman (or a man, even) does not want to be penetrated; if he/she doe then it is sexual intercourse. One person injuring another is only assault because the latter does not wish the former to injure him; if the injury is the result of a consensual contact sport or an unusual sexual fetish then it isn’t. A person’s free speech is only infringed because he wants to speak. If, on the other hand, he is an uncontrollable blabbermouth who talks before he thinks then he may welcome the occasional physical restraint from speaking. In all of these cases where the physical act is consensual there is a harmony of interests – the scarce, physical matter available is directed an end that is sought by both parties and thus there is no conflict. The question of rights only arises, however, when the two parties are trying to direct physical matter towards different ends (and also, we might add, when the cost of resolving the matter in this manner is less than the cost to the plaintiff of fulfilling his ends with other means; if you steal from me a paperclip it is probably cheaper for me to buy a new one than it is to sue you for it; the history of fencing laws is illustrative of the changing economic dimension of rights and obligations). In short, because it is my right it is my choice to waive it when someone else’s goals with the same, physical matter are identical to mine.

Let us re-emphasise, therefore, that the nature of these concepts – rights, obligations, conflicts and so on – were revealed to us through rational reflection upon social interaction, and the distillation of common elements and their justification according to common principles uncovered – not created – the formulae that we libertarians cherish today, such as the individual’s right to private property.

Let us turn now to a different, constructivist conception of what rights and obligations may be – that is that these concepts were deliberately created or invoked by specific persons such as monarchs, leaders or intellectuals. It is clear that if the origin of a proposed right is not the resolution of a conflict arising from the competing valuations that exist in the minds of the parties, it must, rather, be something else. There are only two possibilities. First, a third party constructs a right according to what he hypothesises is a conflict between the parties over the property in question when there is in fact no such conflict. In other words, rather than being a party to a conflict himself, this third person looks upon the condition of other people and declares that they are in a conflict with each other that needs to be corrected with a system of rights. The second possibility, which is joined at the hip with the first, is that the conflict over property results from the valuations of a third party or of a group (such as intellectuals) who call for the construction of rights and obligations according to their own direction. In other words, these people want to distribute property rights according to what they want rather than what everybody else wants when everyone else may, in fact, be living in perfect accord with one another. In both cases the concept of a right has been changed from the resolution of a conflict over scarce, physical goods as perceived by the parties into being the resolution of a conflict over the same goods perceived by somebody else. Your rights and obligations are no longer determined by what you, as a freely acting individual want and value; rather they are defined by some other person. This is something that is markedly different, something that changes not only the definition of a right itself but also the definition of specific rights.

An exaggerated example of the first type of “right” – one that is simply imposed – is a right of each person to air. Intuitively, a right to air sounds more than plausible – after all, a person will live for barely minutes if he is not able to breathe. Surely, as some pioneering progressive might say, it is a travesty of justice that we do not all have a right to something as basic as air?! Under the state’s self-appointed mantle that it needs to ensure that we all have enough air to breathe, perhaps we can imagine exclusion zones round each other’s bodies which no one else may breach in case they breathe “your” air in the zone. Or, needless to say, we could imagine countless other ridiculous “solutions” to this non-problem. Rights to air do not exist, of course, because nobody (yet) conflicts over particles of air. The supply is more than sufficient to meet each person’s need without anyone ever coveting the air breathed by someone else. Hence rights and obligations in this scenario are superfluous and any invocation of them is an unwarranted affront to people’s perfectly peaceful behaviour. (The contrary case – that of taking away rights when they are, in fact, demanded, such as with rights to own animals that are members of an “endangered” species – is of the same ilk, but we need not deal with that here).

With the second type of constructed rights, let us take the right to private property which protects one against, say, theft. If, in order to “protect” my property, this right is no longer defined according to my valuation as to how I best want my property directed – i.e. my willingness to “exercise” my right – it must be defined by reference to something else. This can only be what the imposing party, or his intellectual advisers, regard as their valuation as to how the property is best directed. The resulting prohibited action is no way a vindication of my right to private property at all – if I am perfectly happy for my property to be taken in a particular incident and this is clearly evident then there is no discord between me and the alleged thief, nothing that the imposition of a right needs to solve. What has in fact been accomplished is the voiding of a transaction that the imposing party disapproves of according to his valuations at the expense of the valuations of me and the person who took my property. The critical element required for a generation of rights and obligations – a competing valuation over scarce, physical goods – is held by the imposing party, not by the constructed “rights” holder (i.e. me). Hence, the de facto right – i.e. the ability to have property directed to ends according to which one desires – is also held by the imposing party, not by the constructed rights holder, for it is really the imposing party’s valuation regarding this particular piece of property that is vindicated. Theft has now been constructively redefined from meaning a conflict between a property owner and a person who takes it, into a conflict between those two parties and the state. This is clearly anti-libertarian as it subsumes the desires of all of individual people and permits the imposing party to direct everyone else’s property to its desired end. The result is practically the same as the government simply outlawing certain types of voluntary trade, such as drugs or prostitution.

What we will proceed to explore in part two of this series of essays is precisely how this state of affairs – the movement from rights as a product of human interaction to being a product of explicit construction – came about and how devastating it can be to individual liberty.

A major field of study in the science of economics is the pricing of consumer goods and their antecedent factors of production. The history of this area of thought provides an almost textbook example of the falsehood of the “Whig theory” of historiography – the idea that the knowledge of humanity progresses in an ever upward direction and that what we know now is better and more enlightened than what we knew before. For this area of study in particular is marked by progression, retrogression and progression once more, often with disastrous consequences.

The most serious case of retrogression in this regard was of, course the Marxian labour theory of value that stipulated that the exchange ratio of goods depended upon the quantity of labour time inherent in their production. This theory, together with its corollaries and associates such as the iron law of wages and the exploitation theory, was derived, so it was believed, directly from the largely pre-capitalist classical economics of Smith and Ricardo.

A basic “Austrian” response to this is to reject Marxism and its supposed classical parent by pointing out, of course, that costs are also prices. To explain prices in reference to prices, therefore, would appear to be a case of circular reasoning. Rather, the prices of the factors of production were derived from the value of the final good. Capitalists would bid up the factors of production according to the valuation of the final product. Thus the value of every factor was explained not according to the effort expended but, rather, according to its value in producing consumer goods.

Unfortunately, however, this basic understanding of the “Austrian” approach towards prices ignores the much richer theoretical tapestry inherent in the “Austrian” approach (especially that of Böhm-Bawerk) which, in fact, does not contradict many of the tenets of price theory in classical economics but, rather, armed with the law of marginal utility, provides a more powerful explanatory basis for them. Thus, one need not throw out the classical economics baby with the Marxist bath water and risk losing many of the important and true conclusions that were abused and distorted by Marx.

An immediate problem with the basic “Austrian” view is that the sequence of valuations from consumer good through the stages of production to the ultimate land and labour factors is the reverse of the temporal sequence of events. A product has to have been produced through all of its stages of production before a consumer can bid a price for it. Thus, the prices of the factors of production pre-date those of the consumer goods upon which the former are supposedly based. It is difficult to understand, therefore, how something can be derived from something else that does not yet exist. The more accurate view is, of course, that the prices of the factors of production are based upon the estimated selling prices of the future consumer goods. In a static equilibrium such as the evenly rotating economy the prices of the final goods are known in advance and hence the pricing of the factors of production will accurately reflect the value of the final consumer goods. But as helpful as this model may be in conceptualising the structure of production, it is woefully easy to draw from it the conclusion, so beloved of mainstream economists, that a boost in the value of consumption must necessarily result in a subsequent boost of the value of the factors of production. In other words that consumption feeds production. This, of course, is patently untrue. As John Stuart Mill said, “demand for commodities is not demand for labour”. Rather, to produce a commodity for purchase, labour (and all of the factors of production) must already have been demanded by capitalist-entrepreneurs. In other words, it is production that feeds consumption not vice-versa.

Second, if the prices of the factors of production of a good are based upon the valuations of consumers this does not explain the individual pricing of the factors. If, for example, a consumer will buy a loaf of bread for £1.00, why does the flour that went into it cost, say, 40p, the labour 50p and the hire of the oven to bake it 10p? Why doesn’t flour cost 50p, labour 30p and the oven 20p? Or any other possible combination of prices? One possible answer to this problem is that each factor earns its marginal revenue product – that is, the portion of the value of the increased product that it is attributable to an incremental increase of that particular factor. So for example, if I have a patch of land and a given number of seeds and apply increasing units of fertiliser then each additional unit of fertiliser will be priced according to the additional revenue earned by the additional physical product that results. The problem with this view is that it ignores the fact that no additional product is the result of a single factor alone and that the value of the additional product need not be imputed solely to the additional fertiliser. What if, for example, the purchase price of the land and the seeds already accounted for the fact that additional fertiliser could be applied to it to produce a larger physical product? Moreover, even if, say, the land and seeds were purchased at a price that reflected the fact that only a limited quantity of fertiliser was available and thus only a reduced physical product could be yielded from them, any unexpected increase in the available quantity of fertiliser and thus increased physical product and increased revenue would also cause an increase in the capitalised value of the land and the price of seeds. In other words, there is no reason to assume that the marginal revenue product should be imputed to only a single factor. We are therefore no closer to solving our problem – what is it that causes the particular array of prices between the factors? As we shall see, each factor does, in fact, earn its marginal revenue product, but not in a partial equilibrium where we examine only a particular end or use for a factor. Rather we have to consider the entire assortment of uses to which a good can be directed.

A further problem with the basic “Austrian” approach is revealed when we consider large consumer goods such as cars and computers. It is patently obvious that the value of a car is zero unless it has a steering wheel. Indeed, the demand for steering wheels is likely to be extremely inelastic, stretching all the way up to the height of the value of the entire car. However, in reality, the full value of the car does not result in the imputation of that full value to the steering wheel but rather to all of the other factors as well. Similarly, a computer is useless without the monitor; a television without a plug; glasses without lenses. In fact, it is clear that the utility of thousands of goods is dependent upon the unity of all of their individual components and if any one of them is missing the utility of a particular good drops to zero. Yet in many cases we never have to pay more than a few pounds for the “essential ingredient” to be produced.

How then do we arrive at the prices of all of the individual factors? The answer to this question lies in a deeper understanding of the law of marginal utility. As we know, this law states that the value of a unit of a good is equal to the value attached to the least valuable use to which that unit can be directed. So if, for example, I have five bottles of water, I might use the first for my most important end which is drinking, the second for the next most important end which is washing, the third for cleaning laundry, the fourth for watering plants, and the fifth to make into ice cubes. As each bottle is interchangeable, if one bottle was to be lost it would be the least valuable use – making ice cubes – that would be foregone. Thus, the value of any one unit will equate to the value of the least valuable end of making ice cubes, in spite of the fact that some of those units will be directed to ends with far greater value.

What we can see, however, is that if the value of any one unit of a good equates to the value of the least valuable use to which that unit can be directed then this value must also be imputed to the factors of production. If a portion of those factors was to be lost, the resulting reduced supply of goods would result in the loss of the least valuable ends. Thus, each unit of the factors of production that created the five bottles of water must themselves be valued at the lowest valuable use of a good that those factors will produce.

However, this law will also apply when the factors of production are not specific and can be used to produce any range of goods that satisfy a number of different ends. Let’s say, for example, that a given quantity of factors of production can be used to produce the following consumer goods in descending order of value:

A bottle of water;

A loaf of bread;

A bar of soap;

A pair of socks;

A box of tissues.

If the same factors of production can be used to produce my most valuable good, a bottle of water, as my least valuable good, a box of tissues, then it follows that the factors of production will be valued according to the value attached to the box of tissues. The loss of any portion of those factors of production will result in the cessation of the production of tissues while all of my other goods are still produced. Here, then, is the key to understanding the different prices of the factors of production. The value of a factor is based not upon the utility attached to the specific good to which that factor is directed but, rather, upon the least valuable good to which a portion of its supply is directed. Only highly specific factors of production which can be devoted only to a single end will derive their value fully from that specific end.

In real life, of course, it is never the case that whole combinations of factors of production can be exchanged between different ends. Rather factors have to take their place in different combinations of specific and non-specific factors. It is these various arrays that produce, at any one time, the individual prices of the factors of production. Thus the breakdown of prices of factors used to produce a particular good is derived from the lowest valued uses to which portions of the supply of those individual factors are directed.

We are now, therefore, in a position to see what we mean when we say that a factor of production earns its marginal revenue product. If we gain an additional unit of a particular factor, that unit will be directed towards the next most valuable end that is currently unfulfilled in the economy as a whole. All of the most valuable uses for the factor will already be fulfilled. Yet all units of this particular factor will now be priced according to the value of the marginal unit which will be derived from the least valuable end.

However, the pricing of the factors of production according to their marginal uses is not the only effect of the application of the law of marginal utility. It also affects the value of the supra-marginal products whose direct marginal utility is above that of the marginal product. These products too will be priced according to the combination of prices involved in their factors of production as the loss of any given portion of a factor will not result in the loss of this product but in the loss of the marginal product. Thus, the prices of most goods in the economy are priced according to the least valuable goods that are produced out by the marginal units of their shared factors of production. As George Reisman explains:

Allow me to illustrate Böhm-Bawerk’s point here by means of a modification of his famous example of the pioneer farmer with five sacks of grain. As will be recalled, the five sacks serve wants in descending order of importance. One sack is necessary for the farmer to get through the winter without dying of starvation. The second enables him to survive in good health. The third enables him to eat to the point of feeling contented. The fourth enables him to make a supply of brandy. The fifth enables him to feed pet parrots.

[…]

Now let us slightly modify the example. Let us imagine that the first sack of grain has been used to make a supply of flour, which in turn has been used to make a supply of biscuits, and that it is this resulting supply of biscuits by means of which the first sack of grain performs its service of preserving the farmer’s life […] We can imagine a little tag attached, this time saying, “Biscuits Required for Survival.” As before, our farmer still has four remaining sacks of grain, any of which can be used to make a fresh supply of flour and then a fresh supply of biscuits. And now, just as before, we may imagine rats or other vermin destroying the supply of biscuits. Will the answer to the question concerning the magnitude of the farmer’s loss be materially different? Certainly, his life does not depend on the supply of biscuits any more than it did on the sack of grain. For he can replace that supply of biscuits at the expense of the marginal employment of the remaining sacks of grain, which, of course, is the feeding of the pet parrots. To be sure, additional labor will have to be applied as well, but the magnitude of value lost here is that of the marginal product of that labor, which might be something such as the construction of a sun shade or an additional sun shade or even the feeding of the parrots. The point is that the value of the biscuits will not be determined by the importance of the wants directly served by the biscuits but by the importance of the marginal wants served by the means of production used to produce biscuits and from which a replacement supply of biscuits can be produced at will.1

Thus, we can conclude, that for the majority of products that are available for sale today, their selling prices are based not upon their direct marginal utilities but, rather, upon their costs of production which is derived from the marginal utilities of the least valuable products to which factors of production are directed. There are several noteworthy effects of this analysis.

The first is that this does not nullify the operation of supply and demand in determining the price of any supra-marginal good. Rather, it results in a shifting of the supply curve to the right so that it intersects the demand curve at a level where price equals the cost of production, plus the going rate of profit. Changes in the availability of the factors of production which either increase or decrease their marginal utility will cause similar shifts of the supply curve to the left or right which will have the corresponding effect of raising or lowering the price of the specific consumer good. This is possible without any change in the quantity that is bought and sold if, for example, the shift of the supply curve takes place on a highly inelastic stretch of the demand curve. The same quantity will be bought and sold simply at a higher or lower price.

The second observation, derived from the first, is that this obliterates the standard economic analysis behind monopoly pricing. The basis of this analysis is that suppliers can exploit inelastic demand curves to reduce supply, raise their prices and thus rein in an artificially expanded profit at the expense of the consumer. However, our theory here reveals that the opportunities for doing this are minimal. For the raising of prices and consequent swollen profit margins will cause competitors to shift factors of production away from the production of marginal goods towards an increase in production of the goods whose prices have been raised, thus restoring an increase in supply and the reduction of prices back to near their costs of production. Thus, for any businessman, the primary tool for estimating his selling price is not elasticity of demand of the particular good that he is selling; rather, it is the cost of production of any potential competitor. It is for this reason why very basic goods such as bread, milk, eggs, salt etc. which have an inelastic demand curve are priced very low; and it is for this reason why sole suppliers in particular industries will earn only the going rate of profit; any attempt to raise prices will simply attract competition.

The third important observation is the impact of this analysis on wages. For labour too is, of course, a factor of production and thus will only draw income in line with the marginal use to which it can be devoted. What results, therefore, is that labour is paid a rate of wages that is far below the direct marginal utilities of the goods that the very vast majority of labourers will be producing. Yet it is also clear that, because the value of marginal products is imputed, via their factors of production, to the supra-marginal products, it is clear that the resulting lower prices means that labour can buy all of this produce. Thus increases in the supply of labour, resulting in the direction of the latter to further marginal uses and thus a lowering of the nominal wage rate, will have no bearing upon the ability of labourers, in their capacity as consumers, to buy its produce and, indeed, will serve to increase the real wage rate. Thus the argument that increases in the supply of labour through, say, immigration are largely unfounded.

What we can see therefore is that the “Austrian” understanding of the prices of goods and their costs of production, although complex, provides a strong bulwark against false theories in many important areas such as stimulus spending, wages, and competition law. Every individual who wishes to offer powerful affronts to the falsehoods that abound in these areas should study it avidly.

One of the so-called mandates that our economic lords and masters have arrogated for themselves is that of maintaining so-called price stability, a constant purchasing power of the monetary unit in our wallets. At first blush, price stability sounds rather appealing – not only does it “bless” us with the apparition of certainty but might we not also be “protected” by the potential of higher prices in the future, so we never have to curtail the amount that we can buy and enjoy? If so we can therefore assure ourselves that our cost of living will be sustained and manageable, relieved of the horror that the essential consumables may some day be out of our reach.

Unfortunately this ambition is not only disastrous for a complex economy but is also antithetical to the nature of human action in the first place. The whole purpose of economising action is to attempt to achieve more for less – to direct the scarce resources available to their most highly valued ends and to gain the highest possible outputs with the lowest possible inputs. In short, economic progress means that we are gradually able to attain more and more for the same amount of labour; or, to put it another way, we could attain the same quantity of goods for a lower amount of labour. Any consistent attempt to stabilise the prices in the economy would not only target the goods that we buy with our money but also the goods that we sell – and that for most of us means our labour! But if we cannot sell our labour for any more and if we cannot buy our wares for any less then it means that we will simply be locked into a repetitive cycle of working, buying, consuming and working again for the same prices for the whole of our lives with no improvement in the standard of living whatsoever. Instead of economic progress bringing goods at cheaper prices to the lowest earners, everyone will now have to attempt to be a high earner – i.e. by putting in more labour – in order to accomplish any increase in their wellbeing.

Of course, real price stability never does and never can work in this way for it is impossible for a centralised authority to monitor and regulate all the many millions of individual prices and exchanges that occur every day in the economy. Rather they target the mythical pseudo-concept of the general “price level”, usually concocted by taking a selective index of goods, an index that can be altered conveniently in order to paint the data in the fashion desired. Individual prices within the index, however, may still fluctuate relative to each other even though the absolute price average may appear constant – a fact that may not mean a great deal to the bureaucrat but is of great importance to the individuals who wish to purchase those particular goods. Furthermore, because of the belief that a dose of price inflation is good for a growing economy, “stability” usually tends to be defined as including some measure of price inflation such as the Bank of England’s 2% inflation target. We are apparently “stable” when the government is robbing your pay packet of some of its purchasing power, it seems.

Such a policy is not restricted to existing as a mere moderate tempering of an otherwise healthy and growing economy. Rather, it can have disastrous and deleterious effects upon the entire system. The outcome of a genuinely growing economy with sound capital investment should be a gradual, secular price deflation where goods and services become cheaper over time. If central banks attempt to counter this in order to achieve stability it must lower interest rates and print more money in order to devalue the monetary unit relative to goods in order to prevent prices from falling. However such an act is what induces the ill-fated business cycle; prices may appear stable but the relative prices of capital goods will begin to rise and those of consumption goods to fall as the new money gets sucked into ultimately unsustainable investment projects. This is precisely what happened in the 1920s when a high degree of productivity was countered by a voluminous expansion of credit that masked price rises, giving the illusion of price stability and suckering promoters of the scheme (such as Irving Fisher) into believing that they were living in a new era of permanent prosperity. The same was also true of the run up to the tech boom collapse at the turn of the century and the housing market collapse of 2008; these had been preceded by a period of low interest rates and apparently low price inflation – alleged hallmarks of an successful economy – that camouflaged the underlying distortions, leaving mainstream economists scratching their heads in confusion as to what went wrong.

Far from creating certainty and consistency, achieving “price stability” is one of the very worst horrors of a centralised, bureaucratically managed economy. Let us leave prices – which, after all, are supposed to result from the underlying supply and demand according to individual preferences – to the free market so that we can create a genuinely stable and lasting economic prosperity.

One of the positive indicators of our so-called economic recovery bandied about not only in the media but also by our monetary lords and masters at the head of central banks is the idea that rising prices (particularly in the housing market) are a sign of economic recovery. This mistaken belief is part of a wider myth that views the economy as a big number, a number which, if going up, means things are good and getting better, and if going down means the situation is bad and getting worse.

Theoretically the market price for any good is never “good” or “bad”. It simply a function of supply and demand for that good. However, if anything, relatively high prices indicate a scarcity of goods relative to the money used to buy them rather than an abundance. This situation may be a localised boon to those who are in the business of selling the scarce good, but for those of us on the other side of the transaction having to pay more hardly suggests a general increase in our prosperity. For if society is getting wealthier and producing more goods we should find that we are be able to buy more with the same amount of money rather than less – hence, prices should decline and not rise.

What is of course meant by the “recovery” of rising prices is precisely a localised recovery and improvement for a select group of people – those who borrowed cheap money heavily during the boom (mostly the politically connected big banks and investment houses) and ploughed it into assets. They can now breathe a sigh of relief as the prices of those assets once again begin to rise with the new round of monetary inflation. The rest of us, on the other hand, have to sit by and watch the purchasing power of our wages drop, unable to continue to afford to buy things because the “recovering” prices put them out of our reach.

A general recovery is not based upon rising asset prices buoyed up by paper money. It is created by a sound monetary order that allows entrepreneurs to allocate resources to where they are most urgently desired by consumers. The result should be a gradual secular price deflation, so that the money in the hand of the lowest earners gradually increases in value, enabling everyone and not just the super rich to grow wealthier and more prosperous.

Against the simple and straightforward siren song of “underconsumptionist” and “underspending” theories of boom and bust, “Austrian” business cycle theory (ABCT) can seem contrastingly complex and lacking in communicability. The former types of theory, associated with “mainstream” schools of economics, in spite of their falsehood, are at least advantaged by the veneer of plausibility. A huge glut of business confidence and spending will, it seems, naturally lead to an economic boom, a boom that can only come crashing down if these aspects were to disappear. For what could be worse for economic progress if people just don’t have the nerve do anything? Add in all the usual traits of “greed” and “selfishness” with which people take pride in adorning the characters of bankers and businessmen (again, with demonstrable plausibility) and you have a pretty convincing cover story for why we routinely suffer from the business cycle. ABCT, on the other hand, with its long chains of deductive logic, can seem more impenetrable and confusing. Is there a way in which Austro-Libertarians can overcome this problem?

“Austrian” economics is unique in that all its laws are deduced from a handful of self-evident truths, the most important being the action axiom, often peppered with a few additional assumptions or empirical truths (such as the desire for leisure time). The entire corpus of economic law – right from the isolated individual choosing between simple ends all the way up to complex structures of production, trade and finance – therefore forms a unified and logically consistent whole. This is not true, however, of “mainstream” schools of thought which tend, nowadays, to be splintered and scattered into separate, specialised areas of study that are based upon their own, individual foundations. The fissure between so-called “microeconomics” and “macroeconomics” is a prime case in point; while “Austrians” will read much that is agreeable in “microeconomics” (although it still contains many faults and general misunderstandings resulting from the lack of coherence and soundness that is furnished by deduction from the action axiom), “macroeconomics”, on the other hand, seems to be a completely different ball game, considering only “the economy as a whole” without reference to its individual components1. It is this fact that “Austrians” can use to give them the upper hand when explaining the business cycle. For in ABCT, the explanations of “macro” phenomena are little more than an extension of what is found in “micro” price theory.

The market price for a good is the price at which the quantity demanded equals the quantity supplied. Prices therefore serve to ration goods as a response to their scarcity, the goods available being traded from the hands of the most eager sellers to the most eager buyers. Those buyers who are not willing to pay the market price will go away empty handed and those sellers who are unwilling to sell at the market price will not be able to get rid of their goods. What happens, then, if this relationship is disturbed by a forced fixing of prices by the government? First, if the price is raised above the market price to create a price floor, the new price will attract more sellers into the market for that good because the price that they will receive for a sale is now the price at which they are willing to sell. However, at this heightened price there are fewer people wishing to buy the good. Some, who were not previously prepared to pay the lower, market price, are certainly not going to pay the higher price now. And those who would have paid the market price before may now decide that the new price is too high so they also do not buy. What results, therefore, is an increase in sellers and a decrease in buyers which can lead to only one thing – a surplus of unsold goods. The sellers may be very eager to sell at the new price but they will have a hard time finding anyone to sell to. Secondly, the opposite case, where the price is lowered below the market price (a price ceiling) creates, as one would expect, the opposite effect. This new price will attract more buyers into the market for that good because the price that they will pay for a purchase is now the lower price at which they are willing to buy. However, at this lowered price there are fewer people wishing to sell the good. Again, some, who were not, before, prepared to sell at the market price, are certainly not going to sell at the lower price now and those who would have sold at the market price may now decide that the new price is too low so they also do not sell2. What results, therefore, is a decrease in sellers and an increase in buyers which, clearly, leads only to a shortage of goods. Buyers will swarm into the marketplace eager to purchase the articles at the new, attractive price but, to their dismay, the shelves will be empty, cleared out by all of the more hasty buyers who got there before them3.

It is this latter scenario – that of artificially lowered prices – that is relevant for ABCT. For the business cycle is, according to “Austrians”, little more than price fixing on the widest scale, the fixing and the manipulation of what is possibly the most important price in the economy – the interest rate on the loan market. Rather than being the price at which a single good is traded, the interest rate is the price at which saved funds are borrowed and lent (i.e. demanded and supplied) in the economy.

When the stock of money is fixed, if one person wants to borrow (demand) money then another must have saved it in order to lend (supply) it. The resulting rate of interest is the point at which the quantity of money saved/lent equals the quantity of money borrowed. Any borrowers who want to borrow at a cheaper rate and any sellers who want to lend at a higher rate will find themselves priced out of the market for loanable funds, the sub-marginal buyers unable to borrow any money and the sub-marginal lenders unable to lend any. This situation produces a stable amount of saving, lending, borrowing and investment because the interest rate – the price of saved funds – is in harmony with the preferences of consumers, in particular, their preferences for allocating their funds towards either capital or consumer goods. The portion of his funds that the saver retains for consumption will be spent on consumer goods (i.e., present consumption) whereas the portion that he allocates towards saving and lending for investment will be spent on capital goods that will not provide any immediate consumption but will provide a greater amount of it in the future. At the market rate of interest goods and resources in the economy will be allocated in harmony with these desires. If, for example, a borrower wishes to borrow money to build a factory (a capital good) and his calculations reveal that the prevailing rate of interest is low enough for him to make a return on this enterprise, it means that savers are willing to lend a sufficient quantity of funds in order to make it viable. If, however, the prevailing interest is too high it means that savers are not willing to lend enough funds to build the factory – the money that could be spent on building the factory they would prefer to spend on their own, immediate consumption4.

What happens, then, if the rate of interest is set below the prevailing market rate? Exactly the same as what happens when prices are forcibly lowered for any single good. At this rate borrowers who before found the rate of interest too high for their ventures suddenly find that they can afford to borrow. The quantity of funds demanded, therefore, will rise at this new, low price. Savers, however, will be less willing to lend at this price. Certainly if they weren’t prepared to lend at the previous rate of interest they will not be induced to do so by an even lower rate and some savers who were prepared to lend at the market rate will not be prepared to do so at the new, artificially fixed rate. The increase in borrowers and decrease in sellers, therefore, causes a shortage of saved funds, or at least it should do so. Why, then, does this shortage not materialise immediately at the point that the interest rate is fixed? Why aren’t the banks empty of cash and why can they keep on lending and lending and lending? Why can this situation perpetuate for years and end in a calamitous crash that causes almost unrelenting havoc?

This is where a degree of complexity enters the explanation. What is really being borrowed and lent is not money but, rather, the real goods and resources that they can buy. We said above that if someone wishes to borrow money another person has to have saved it. But what this really means is that the saver has to have worked to produce real goods and resources in order to earn that money. He then lends that money to the borrower and the borrower uses that money to buy those goods that the lender produced and diverts them towards his enterprise. If, of course, saving, lending and borrowing took place with real goods, or if the supply of money was fixed, then obviously a forced lowering of the rate at which these goods could be borrowed would result in their shortage very quickly. But the fact that the saving and lending takes place through the mechanism of an easily expanded paper money supply creates a clever smokescreen. For our entire financial system rests not on the principal of every pound borrowed requiring a pound to be saved, but rather that pounds can be “created” out of thin air by the central bank and lent out even though someone has not saved. By printing fresh money (or its digital equivalent) the volume of borrowing can expand without a corresponding expansion of the volume of saving. This easy ability to produce more money to meet the higher demand for borrowing means that the artificially low interest rate never causes a shortage of money as we would normally expect when the price of any other good is fixed below its market price. A second problem, though, is that the real goods that this new money can buy have not increased in line with the increase of the supply of money, but, rather, have remained constant and there is, therefore, still only the same quantity of goods that have to be allocated towards either consumption or investment. Surely the artificially low interest rate will mean that there will be a shortage of real goods to devote towards investment?

Unfortunately, at the beginning, this is not so. For the newly printed money transfers purchasing power over goods out of the hands of those holding existing money and into the hands of those who have the new money. The result of this is that the borrowers of the new money – those who want to devote the goods purchased to capital investment – now have an advantage over those who wish to devote them to consumption. Let’s say, for example, that I earn £1000 in a given month. This means that I have worked for and created real goods in the economy on which I can spend this £1000. Let’s say that I allocate £750 towards consumption and £250 towards saving and investment. Therefore, what I want to achieve is toconsume 75% of the goods on which I can spend the money and save and invest 25%. This £250, the 25% of the goods I wish to devote to saving and lending constitutes supply in the loan market that will help to set the market rate of interest. We can illustrate this allocation accordingly:

Consumption £750 75%

——————————

Saving £250 25%

——————————

TOTAL £1000 100%

If, however, a commercial bank depresses the interest rate and simply prints an extra £500 to meet the new demand at this lower rate, what has happened now? There has been no change, remember, in the quantity of goods – the new money must be still be spent on these goods. The purchasing power of the existing money that I wished to spend on consumption therefore reduces and that of the new money that is to be spent on lending and investment correspondingly increases. All that happens therefore is that the proportion of goods that can be devoted to lending and, hence, to investment has now been forcibly increased from £250 to £750 – and increase from 25% to 50% of the new total stock of money, thus:

Consumption £750 50%

——————————

Saving £250 17%

New Money £500 33%

——————————

TOTAL £1500 100%

Newly printed money that enters the loan market therefore forces the economy onto a different consumption/investment ratio from that which is desired by consumers. The poor consumer will find that the newly created money has caused the prices of goods to rise; he is forced, therefore, to curtail his consumption in real terms. The goods that he can no longer afford to buy and consume will be purchased by the new borrowers who will devote them towards their capital enterprises. It is for this reason that none of the expected effects of price fixing occur and the economy proceeds along what appears to be a sustainable boom in capital investment. The problem, though, is that capital projects usually take several years to complete and rely on a continuous supply of goods throughout this time. But consumers don’t want to save voluntarily the amount necessary to complete these projects. The interest rate must therefore be constantly kept low and the new money reeling off the printers to meet it if the projects are to continue. It is only down the line when price inflation inevitably begins to accelerate and the central bank forces an increase in the interest rate and a corresponding reduction in growth of the money supply that the problems are revealed. For now the consumption/investment ratio once again begins to reflect the preferences of consumers – they want, if we remember, more consumption and less saving which means that lending and investment has to reduce. Hence half-finished capital projects have to be left incomplete. They have been starved of the resources necessary as they can no longer afford to purchase them at the new rate of interest. This precipitates a collapse in the prices of capital assets, a collapse that causes widespread bankruptcy and liquidation of firms and enterprises that, hitherto, had seemed sustainable and profitable. Ludwig von Mises describes the perfect analogy:

The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal5.

Mises’ last sentence is important. As the prices of capital goods were accelerating upwards during the boom and then suddenly come crashing down, there is a temptation to analyse this as “overinvestment”. While this is true and that “too much” has been devoted to long term investment projects it should be clear from our analysis that the real problem is malinvestment – a diversion of resources from desired consumer goods to capital goods.

Observant readers might say that it is actually the return to the market rate of interest and not the fixed rate that has caused the sudden shortage of capital goods. This would not be a correct interpretation. Artificially lower prices always give the illusion of plenty, of abundance and availability for everyone. It is just that with the fixed price of a particular good the illusion becomes obvious more quickly. But with fixing the rate of interest, because it takes effect through the mechanism of money, the illusion of plenty is obscured and, for a time, looks very sound. For this new money has the very real ability to divert resources away from consumption towards capital investment. Nothing more has been created but it looks like there has. Couple that with price inflation with higher nominal wages and people, at least, think that they are better off than they were before the “miracle” of artificially low interest rates. Real abundance and plenty, however, would not merely divert resources from consumption. Rather, resources for capital investment would exist independently of and in addition to those desired for consumption, as dictated by the desires of consumers.

Conclusion

What we have seen, therefore, is that ABCT sits coherently with the examination of individual price action and is little more than an extension of it. The business cycle is simply a case of price fixing writ large, causing widespread waste, chaos and misery when its effects are finally revealed. There are no separate bases or foundations of this “macro” sphere of economic theory. There are, however, certain special features that make this form of price fixing especially insidious and long-lasting – that of the easy ability to print fresh money to meet the new, low rate of interest, permitting purchasing power to be transferred to new borrowers and, hence, the real diversion of resources. As soon as this situation ceases the smokescreens vanish to reveal the waste and futility of these diversions.

Whenever, therefore, one has difficulty in either understanding or explaining ABCT, think back to what you know about simple price fixing. In fixing the rate of interest, the most important price in the economy, “Austrian” economics, with its strict deductive logic from the action axiom, will tell you that the results will be the same.

1Murray N Rothbard, Man, Economy, and State with Power and Market, p. 269 (n. 19).

2This isn’t just stinginess on the part of sellers; rather, the cause of their unwillingness to sell will be, in the long run, that they simply cannot – the lower price will usually not be sufficient for them to recoup the costs of production so they have to abandon the particular line altogether.

3These results were seen during the high inflation of the 1970s in the US when price controls led to long queues at gasoline station because the demanded quantity of gasoline could not be supplied at the artificially low price.

4An interesting question is whether the interest rate may strictly be considered a “price”. In the exchange of goods, the price of a good is the quantity of another good that is fetched in exchange. For example, if one apple sells for two oranges, then the “orange” price of an apple is two oranges (and the “apple” price of an orange is 0.5 apples). In the complex economy, of course, every good is exchanged for money so we always reckon prices in terms of the quantity of money received in exchange. However, whatever the other good that is received, it makes no sense to compare the two physically heterogeneous goods in terms of magnitude. For how does one calculate the “difference” between two apples and one orange, or between £2.00 and a bag of oranges? In the exchange of a present good for a future good, which is what happens in the loan market, this is not the case, however. If a borrower agrees with a lender to borrow £100 today and to pay back £110 in one year’s time, strictly the price of one unit of present money is 1.1 units of future money (or the price of 1 unit of future money is approximately 91p of present money). But because the two goods are physically homogenous we can compare the two magnitudes – 1.0 and 1.1 – in order to derive a rate or ratio between them of 10%. We would therefore state that the interest rate per annum in this scenario is 10%. This rate is therefore not strictly a price but an expression of two prices – the price of present money in terms of future money and the price of future money in terms of present money. However, it should be clear that a manipulation of the rate of interest would have the effect of fixing the actual prices of present and future money. If, for example, the interest rate is forcibly lowered to 5% then the price of one unit of present money is now 1.05 units of future money rather than 1.1 units of future money. The resulting effects of price fixing will therefore be felt in this scenario. Hence, it makes sense to speak of the rate of interest as a price just like any other and, indeed, this is how it is treated by acting humans in the loan market.

One of the most vilified activities associated with the capitalist economy is that of speculation. Even in a world where managers of large multinational firms and wealthy shareholders are denigrated as evil, greedy and exploitative, the full brunt of the most concentrated ire is directed towards the class of persons branded as speculators. Indeed they are a convenient scapegoat for a whole host of (often contradictory) symptoms of an ill economy or financial system – rising prices, falling prices, volatility of prices, inflating bubbles, bursting bubbles, price gouging, supply shortages ad infinitum. Even successful investors and their mentors – Warren Buffett and Benjamin Graham respectively, for instance – are keen to point out how their methods differ from speculation and reserve the word for describing arbitrary, capricious, and undisciplined trading. More than any other aspect of the free market, then, it would appear that speculation is in need of the most detailed clarification and defence. What will be elaborated is that speculation is endemic not only to all exchange, trade, business, production, etc. but also to the very nature of human action itself. Further, following an explanation of the different ways in which it is possible to speculate, it will be demonstrated that no principled distinction can be made between anyone who tries to “buy low and sell high” and that perceived differences that are used as grounds for criticism are instead based on the relative difficulty in visualising the true economic effects of some speculative activities.

Valuation and Human Action

Humans act because they wish to direct the scarce resources at their disposal to and end that is more highly valued than the alternative use to which those resources may be put. If this was not true humans would not act. All human activity, whether it is brushing one’s teeth or purchasing a bag of groceries right up to selling a house or trading billions of dollars worth of securities on the financial markets are all carried out because the acting individuals perceive that the value of the outcome is higher than the value of the alternative. I brush my teeth because the act, I believe, will produce clean teeth that I value more highly than doing something else while retaining dirty teeth. I buy the groceries because I value them more highly than the money I am using to pay for them and other things that I could have bought. I buy a house or securities on the financial markets for the same reason.

However all valuation is ex-ante, that is we must decide what the valuations of our outcomes are before we act. We do not act out all of the different things we could do with our resources and then cherry-pick the one that actually yields the most valuable outcome. Rather we have to anticipate that the resources chosen and the method of our action will actually bring about the end that is sought and that this end will indeed have the value that we believe it will have. In short, we speculate on the outcome of our actions and all of our actions are, therefore, speculative.

Different actions have differing degrees of speculation, particularly when we have experience of the outcome. Most people will be fairly confident as to the results of brushing their teeth, both in terms of the physical product and the value it has. It’s not likely that after the act of brushing the teeth will be in a condition we did not expect, nor are we likely to regret what we have done and wish we had done something else. Further we are not likely to have undervalued the outcome ex-ante and end up wishing that we had devoted even more resources to produce more of the outcome. Other actions, however, are less certain. When a person buys a new product from the grocery store he doesn’t necessarily know whether the enjoyment of the taste and the satiation of hunger will outweigh the money spent on it. In order to mitigate this uncertainty he may at first be reluctant to devote too many resources to it, perhaps only displaying a willingness to purchase it when its price is reduced. After he has eaten it he may feel that he made a satisfactory trade and that he is glad that he purchased the good for the amount of money he gave up; alternatively the meal may be so ghastly that he deeply regrets the experiment and, if he could go back in time, would keep the money and not buy the product. However another possibility is that it might be so enjoyable that he regrets not having spent more money on the good and that the other uses to which he devoted another part of his money ended up being wasted as a result.

The point, though, is that all valuation of our actions is made ex-ante and that they are, therefore, speculative. Even with a commonly repeated act such as brushing one’s teeth there is no certainty. What if the time you devoted to brushing your teeth caused you to miss something important on the television and that, if you had your time again, you could go back and leave the brushing until after the show had finished? Speculation is, therefore, not only an essential and undeniable aspect of human action, one that we are immutably bound to using, but the very generator of human action itself – it is the impulse of our belief that we are moving on to something better with each act that causes us to act. It is no exaggeration to say, therefore, that speculation is at the heart of the nature of human living. Everyone is a speculator.

Market Participants and Exchange

Having established, therefore, that speculation is the anticipation of value arising from an action that is greater than that which preceded the action, let us narrow our focus to where speculation is typically used as nomenclature for these activities of valuation – the marketplace. But are we to crown only those traders who stare at price charts on six computer screens all day as “speculators” or is the scope of the definition much wider?

The “free market” (a much-abused term usually deployed by those opposed to it to signify disconnection from and lack of control by “ordinary” people) is an abstraction for people, individuals, voluntarily buying and selling. But why do they buy and sell, or to use a more precise phrase, why do they exchange? Here we come to a second important law of human action – that in order for two individuals to exchange goods, each must value the good that he receives more highly than the good he gives up. If A owns good a’, B owns good b’ and they agree with each other to exchange these two goods then it must be because A values good b’ more highly than he values good a’ and B values good a’ more highly than he values good b’. If this was not true why would the exchange happen? If the good you wished to acquire you viewed as equal in value to the good that you give you up why bother to exchange it? If it is of equal value what are you gaining from the action? Any doubts about this truth can easily be purged by considering one’s own experiences. You work to earn money but you cannot eat money and it cannot provide you with shelter, clothing, etc. At some point you need to buy goods that will remedy these deficiencies and you do this because the goods become more valuable for you than the money. Conversely the vendor of the goods wants your money more than he wants the goods.

It follows therefore that if market participants are attempting to gain value through trade, and the value can only be anticipated in the way that was outlined above then aren’t all market participants speculating? Aren’t we all expecting that what we gain from an exchange will be of greater value than that which we gave up but live with the fact that our expectation might either turn out to be true, turn out to be really true to the extent that we wished we’d exchanged more or turn out to be so untrue that we really wished we had not made the exchange? Everyone in the marketplace is therefore a speculator and all market transactions are speculations – speculations on what is gained in exchange will be more valuable than what is given up.

Let us concentrate, however, on the market participants who buy and sell, i.e. the relationship of exchange does not end with their purchases as in the case of a consumer. Consumers, after all, are expecting psychic gain. When a consumer purchases a steak he is expecting the enjoyment gained from eating it to be greater than the money he gains from it. With other market participants, however, the goods they exchange are not for their final enjoyment – they are to be bought with the desire to sell them again in due course. Here we have the starkest and simplest way of determining a gain in value from an exchange – that the price at which you bought a good is lower than the price at which you sell it. All market participants other than consumers aim at this end. And once again the participants can only expect that the good will sell at a price higher than the price at which it was bought. All market participants are, therefore, speculators and the object of their speculation is the variation in price of an economic good. It does not matter who you are – a corner shop, a restaurant, a bank, a large multinational firm, a derivatives trader – all speculate that the price at which they purchase the factors of production will be lower than the price at which they sell the final article to their customers. Price movement, therefore, is king to the speculator.

Prices

It is an economic law that the market price is a function of the supply of an economic good and its demand. If the market price is at a level where the quantity of the good that is demanded is equal to its supply then the price is said to be at the equilibrium price, or the “clearing” price. As the quantity demanded equals the quantity supplied all willing market participants – buyers and sellers – are satisfied at this price. All of the willing buyers go home with however many units of the good they wished to buy and all the willing sellers go home with however many units of money they wished to sell for.

It follows, therefore, that if there is a change in supply or demand then one set of people must become unsatisfied. If, at the current price, demand increases but supply remains constant there are now, suddenly, not enough willing sellers to supply the goods to all of the willing buyers. The result is that price must rise to a point at which the willingly supplied stock can be rationed to the sudden influx of new willing buyers at the old price. Conversely if supply increases but demand remains equal then price must fall to a level at which the increased supply can find new, willing buyers who were not prepared to pay the higher price.

Disequilibrium in the relationship between supply and demand therefore causes prices to change. It is the ongoing and varying disequilibrium that causes the price movements in goods that we commonly associate with speculators – in stocks, bonds, currencies, commodities, real estate etc. But the currents of supply and demand are common to all prices, even those that appear to hardly change at all from day to day.

As we already established a speculator in the marketplace is a person who “speculates” on the prices of goods – he believes that the price which he pays for a good today will be lower than the price that he is able to sell it for in the future. But, as we just explained, this can only happen if there is disequilibrium in the relationship between supply and demand. What follows, therefore, is an important, applied economic law that is seldom realised by even the market participants themselves: that anyone who buys goods in the marketplace with the desire to sell them at a higher price at a later date is necessarily intending to buy at a price level where demand already or shortly will exceed supply, necessitating a rise in price, and to sell them either when price reaches equilibrium or when supply exceeds demand. All persons who buy and sell aim to do so at these points. All market participants are therefore speculators on the disequilibrium between supply and demand. There are no exceptions to this law – every investor, entrepreneur, manager, businessman, capitalist, shopkeeper, distributor, agent, anyone you can think of who wants to “buy low” and “sell high” must and can only find the places where demand and supply are in disequilibrium. It follows that the buying and selling where the disequilibrium is greatest will yield the most handsome profit margins.

Methods of Speculating

We are now getting closer to the area where the most common grumbles about the act of speculation lie – that the speculator just buys something, sits on his rear end, waits for the price to rise and then sells it. “But what on earth has he done?!” cries the typical lament. “What value has he contributed? How has he improved the situation at all and why should I pay this person a ludicrously high profit?!” Such vitriol is usually reserved for certain types of market occupation – investors, bankers, middle men, and agents for example. But we must remember that all market participants are speculators and so there is more than one way of anticipating where and how the supply and demand for a good will change. Further, as will be demonstrated, all speculators, in whichever occupation they are working, must, if they are successful, add value.

What, then, are the methods of speculating? What is the focus of the individual speculator when he is buying low and selling high? They are one of three things – that the speculator must either a) transform the good into another good, b) change the location of the good or c) change the time of an economic good. Little needs to be said about a) except that it always involves a material transformation of a combination of goods into the final good; b) is effected by transporting the good from one location to another; and c) by buying it, withholding it from circulation and selling it at a later date.

In practice, of course, it is an economic fiction to treat these aspects entirely separately; for a start all methods of speculation must take place through time. Further we could argue that a change of time or a change of location is also a change of form – that, for example, oranges in Florida are a different economic good from oranges in London, or that Christmas trees at the height of summer are a different good from Christmas trees on December 25th. However from the point of view of the physical actions and preoccupations of the speculator they are separable and analytically different methods of speculating. How then do these methods of speculation take advantage of changes in supply and demand?

If a speculator transforms an economic good then he takes pre-existing goods and turns them into another good, a finished product for sale. It is easy to envisage this as almost every manufacturer fits into this category, whether he is a sole trader or a large factory. A carpenter takes wood, tools, varnish and his labour and produces may be a table or a chair. A printer takes plain paper, ink, staples or binding fluid, and labour and turns out a book. A car plant or plane manufacturer takes hundreds of factors of production in order to turn out their products. Such transformation can take place with previously produced goods or with land (in the economic sense). The carpenter’s wood, for example, has already been transformed from a tree into a plank, whereas a farmer has to take land, seeds, water sunshine and labour and turn them into crops. Further, the transformation is not limited to tangible goods but also to services. A taxi driver will take a vehicle, fuel, a payment meter, his labour and produce with them a journey for a customer. Nothing physical that the customer can hold in his hand results, but the factors have combined to yield a valuable, intangible good.

How is it, then, that a transformation produces the all important increase in value, indicated by aiming for selling the produced good at a price higher than the price of the individual factors? It can only be by buying factors that are in low demand relative to supply and transforming them into a good that is in high demand relative to supply. The several economic effects of this service are important. First, it discovers an economic inefficiency that is ripe for correction – factors that are used to produce a good that is highly valued are, in and of themselves, relative undervalued. The larger the profit margin the greater the extent of this disequilibrium. Secondly, such a discrepancy means that the factors, because of their cheapness, will be directed towards production processes with less valuable ends and will be conserved with less zeal. Hence factors that could be used to produce a highly valued end are, in and of themselves, being wasted on lesser ends. When the speculator begins to buy these factors he creates for them an additional demand. This additional demand drives up their prices, rendering them too costly for other, less valuable ends and diverting them instead to the more valuable ends. Hence resources are no longer wasted. Finally this discovery of the discrepancy and its subsequent correction, yielding a large profit margin, will encourage competitors to enter the field. Thus, the factors will be bid up even more thus driving their price up further while the supply of the finished product will increase, hence lowering its price in turn. Profit margins therefore decrease as the increasing cost of factors approaches the decreasing selling price of the final good. Investment will continue to increase and the industry to expand until profit margins no longer justify it and funds are attracted to other projects whose discrepancies and imbalances have now become relatively more pressing. Hence speculation – the discovery of imbalances between demand and supply – prevents the waste of resources by identifying wide profit margins and closing them. As result the scarce factors of production are directed to their most highly valued end. And this is the essence of economic efficiency, getting the greatest value out of scarce resources1.

However, there is no guarantee that the speculator’s buying prices will be higher than his selling prices. Just as the consumer does not know in advance whether the new product he bought from the grocery store will end up being worth the money spent, so too does the speculator not know whether the price of the good he sells will be higher than that of the goods that he combined to produce it. It may be that his customers are satisfied with the product and will purchase it at a modest premium, in which case he identified a discrepancy in the market but it was relatively minor. He has provided a service but the factors of production clearly have very competitive alternative ends into which they could be drawn, otherwise their price would have been lower and the profit margin higher. The speculator has therefore done an important service, but not one of tremendous magnitude. Alternatively the customers may be absolutely delighted with the new product and rush to buy it as quickly as possible. Demand is so high that the speculator can barely keep up with orders and the only way to ration the existing stock is to raise the price. The increase in price will, therefore, increase profit margins. Hence the speculator here has identified a very wide and serious imbalance in the economy, a pressing and urgent desire of his customers for a product whose factors were highly under-utilised. Or, the undesired outcome, the speculator finds that he cannot sell his finished product for more than the factors of production and that he therefore makes a loss. He has, erroneously, diverted factors that were in high demand relative to supply and transformed them into something lower in demand relative to supply. Hence the factors have been wasted as the high demand for these factors indicates that there were more pressing needs to which they could be diverted. However, the waste is quickly cut short because no market participant wishes to or even can sustain losses. At some point, even if he persists with the loss making enterprise, there will a come a time when he runs out of money. He therefore loses the ability to continue to divert resources to wasteful ends and his proven lack of talent for speculation eliminates him from that role in the economy. The successful speculators however, in gaining profit, are able to command more resources than they were before. Their successful identification of where to divert the scarce factors of production means that they are trusted with being able to do so again with more. But if they make one error in identifying the desires of the consumers they will begin to make losses. They must therefore be continually successful in identifying the most pressing needs of valuable economic resources.

As we have already said speculation is necessarily forward looking – the anticipation that the value yielded by an act is greater than that of what persisted before. When it comes to the speculator who buys and sells goods what we see is that the valuation runs in a direction reverse to that of the sequence of events. The first speculator in what could be a very long chain of production is motivated by the valuation of the final consumer (who may not appear to buy for many months or even years) that is expressed through the chain by the valuations of all the other speculating intermediaries and directly by the particular speculator who will purchase his product from him. All speculators are, therefore, acting ultimately in the service of the final consumer by ensuring that scarce resources are directed to their most pressing needs.

Having explained the economic effects of speculation with reference to speculators who transform economic goods the remaining categories can be elaborated relatively swiftly. However with transformation it is relatively straightforward to visualise the productivity of the speculator; indeed the word speculator is seldom associated with what are perceived as routine businesses. This, as we have shown, is a misunderstanding as all actions are speculative and calculably so when they involve buying in order to sell for money. However with speculators who change either the location or the time of a good understanding of precisely what is going on becomes more obscure, resulting in the perception that either these types of speculator are either adding no value or, worse, are actively destructive and exploitative. These beliefs will be demonstrated to be false.

With the speculator who changes the location of an economic good we have the first case of the dreaded middleman – the agent, the dealer, the distributor and the marketer. These people buy an economic good, do absolutely nothing to change it and then sell it for a higher price, so the argument goes. If however, they are not adding value then it raises the question of why people are willing to pay the mark-up. Are the speculators simply ripping people off or is there a genuine reason why they are able to sell their goods for higher than the price at which they bought them?

Let us take the example of the distributor. He buys goods in one location, transports them to another and sells them at the latter. But why is he able to sell them at a higher price at the final location? Going back to our analysis of prices it can only be because the goods at the original location are in lower demand relative to supply whereas the goods at the final location are in higher demand relative to supply. In other words the speculator has identified an imbalance in the market – goods at one location are plentiful and lowly valued relative to another location and the speculator steps in to correct this imbalance. This is straightforward to perceive with goods that can only be manufactured or produced at certain locations on the Earth either because of climate or because of the ease of access to raw materials. Let us assume that a certain good, oranges, can only be produced in Spain. At that place there is a very heavy supply of the oranges as the crop ripens – baskets and baskets of them are stacked up in the groves. Oranges may be so abundant that they exchange for pennies and people devote their use to meet all sorts of ends – eating, juicing, garnishing, animal feed etc. However at other places on Earth – let’s say, London – oranges are not produced at all and are in very short supply. Consequently they trade for a very high price and as soon as someone gets his hands on an orange he will conserve it and take extra care to make sure he devotes it to his most highly valued use (lets say eating). It is unlikely that you would find Londoners using this rare fruit as animal feed.

The actions of the speculator who steps in in this case differ in no way at all from the speculator who transforms goods. His buying action will drive up prices in Spain that curbs the relatively wasteful uses to which oranges are directed; his selling action will drive prices down in London, allowing more people to enjoy the fruit and to devote it to a wider number of uses than they could before. The height of his profit is determined by and will demonstrate the height of the economic imbalance between the two locations, encouraging competitors to also enter the field and continue the buying in Spain and the selling in London, thus reducing profits. This will continue until the return no longer justifies the costs of transportation2. Therefore just as where the transforming speculator brought about a unity in price between the factors of production and the final product the speculator in location brings about a uniform price for goods across all places (less transportation costs). Thus economic resources are not just channelled to their most highly valued form but also they are transported to their most highly valued location.

Economically the speculator in location is no different from the speculator in form its just that the focus of his operation, his expertise, is location and not form and it is, hence, analytically easier to deal with them in these categories. However he does take factors – oranges in Spain, wooden crates, trucks, fuel and labour – and transforms them into oranges in London and the latter is really a different good from the original. Hence he has produced a good in a different form except that this is not evident from the physical quality of the final good. It is this obscurity that leads to questioning over the added value of this type of speculator’s activity.

It could also be said that a further benefit of the speculator is that he eases the burden of the previous producer. For example, by buying the oranges from the farmer the speculator relieves the latter of having to find a market for his product. The farmer receives a definite price now rather than having to, himself, arrange for transportation, marketing and whatever else in order to sell his product elsewhere on the planet. He can therefore concentrate his time and resources on farming the oranges. The car manufacturer sells to a dealer so the latter then takes on the burden of having to sell them to consumers. The same is true also of those who change the form of goods – the carpenter relieves the lumberjack from having to fashion the wood into tables and chairs; the goldsmith does need to learn how to fashion jewellery as the jeweller will buy the gold from him and do it instead. Hence the more speculators there are trying to analyse differences between buying and selling prices in different markets then the greater becomes the extent of the division of labour – each market participant only needs to concentrate on and consider a very small section of the entire economy and may be completely unaware of where his factors came from and where his final product will end up. Such specialisation leads to enormously greater productivity and, indeed, is the very raison d’être of the extent to which humans have, at least in some parts of the world, achieved a standard of living far in excess of that when they first walked the Earth.

Finally let us turn our attention towards the speculator who changes the time of an economic good. Here lies the, apparently, most lazy and undeserving of all speculators – the person who buys something, holds it then sells it a higher price while having added nothing of any value whatsoever. Such a point of view again overlooks an analysis of supply and demand3. If the speculator buys at a time when prices are low it must be because the demand for the good is low relative to its supply. Nevertheless the speculator is anticipating that demand will rise at a point in the future, a point that will cause prices to rise and allow him to sell at a profit. If the speculator is correct, therefore, then it means that the good in question will become, in the eyes of the consumers, scarcer than it was before. Something that today is relatively valueless will tomorrow become desperately sought after. The speculator’s buying actions therefore serves to remove the good from circulation at a point when demand is low. This removal prevents it from being wasted by a diversion to a less urgent use today when it will be needed for a more urgent use tomorrow. Once prices have risen as a result of the anticipated increase in demand, the speculator releases the good for sale on the market again, but now only those that most value the good will be willing to pay the higher price. Hence the resource will be devoted to its more urgent uses. Speculators in time therefore conserve resources in times of plenty and release them in times of scarcity. It is almost exactly like the squirrel who, during the summer and the autumn when nuts and fruits are in abundance, abstains from consumption of a part of them and stores them away. Come the winter and the spring when these goods are scarce he has plenty to consume that he would not have had but for his saving and storage. Indeed, seasonal products or products that have a long period of production (the longer the production period the more uncertain the final selling price of the good) are those that are ripest for speculation in time. The general effect of this speculative activity on the market is a reversion of prices to the average. If we assume, for the sake of simplicity, a constant demand for wheat during the year, at harvest time there is plenty of wheat to satisfy this demand and so prices will be very low. Wheat will be so cheap that people will gobble it up and devote it to minor and un-pressing needs on account of its abundance. However in the winter wheat will be very scarce and will therefore command a high price. There will not be enough to go around and what little there is will be devoted only to the most urgent needs. However in summer the speculator, by introducing additional buying pressure when prices are low, will drive prices up towards the average annual price and in winter, by introducing selling pressure when prices are high, will push prices back down to the average. The result, therefore, is a stable, annual price for wheat throughout the entire year in spite of the seasonal variations in supply. This is why consumers are able to pay the same price throughout the year for grocery products that are produced with seasonal factors of production.

Similarly to other forms of speculation the height of the difference between the buying and the selling prices determines the scale of the economic imbalance, most noticeably after poor harvests. In these years speculative action, reaping handsome profits because the price rises so high, serves to conserve what little of the crop there is for those who need it most urgently.

Of course those speculators who behave contrary to what supply and demand are doing – those who sell when prices are low and hence drive down the price even further when the good is in hot supply, or those who buy when prices are high thus choking off even the most willing buyers from being able to purchase the good – will quickly lose funds and go bust, ending their short reign of destructive buying and selling. For no speculator, in the long run, can change the ultimate direction of prices; every speculator who buys at some point has to sell. His buying pressure that raises prices today will become selling pressure that lowers them again tomorrow. The overall price and its movement can only be determined by original supply of a good by its producers and the final demand by its consumers. The alleged volatility of prices and bubble formations that are allegedly caused by speculative activity will be dealt with below.

A further benefit of speculation in time is the correction of momentary price discrepancies. A seller offers a good for sale at a price below the market clearing price where demand outstrips supply. The speculator purchases the good and offers it for resale at the market price, pocketing the difference as profit. By purchasing at the lower price the speculator ensures that sub-marginal buyers are not able to get their hands on it and divert it to less urgent uses; by selling it at the higher price he conserves the good for the marginal and supra-marginal buyers who will divert it to more urgent uses. Conversely a buyer may offer to buy a good for higher than the market price where supply exceeds demand. Here the speculator will short sell the good, borrowing it and selling it at the higher price before buying it back at the market price and returning it to the lender. This means that sub-marginal sellers are not able to sell their goods ahead of the marginal and supra-marginal sellers, ensuring that the former cannot crowd the market with wasteful surpluses that will find no buyer at the high price.

It should be clear that the speculators’ profits in cases of momentary price discrepancies are funded entirely by the erroneously dealing sellers who sell too low or the erroneous buyers who buy too high. They must bear the penalty for trading at a price level where supply and demand are not in equilibrium. Those buyers and sellers who are prepared to trade at the market price do not suffer at all; indeed buyers are benefited by the prevention of a shortage of stock resulting from prices below equilibrium and sellers by the prevention of surplus stock resulting from prices higher than equilibrium. Of course if the speculator himself is on the wrong side of these trades then he is the one who is punished with losses. If he, for example, suspects that the current price is below the market price whereas it is in fact at or above the market price, he will buy and then attempt to sell at an even higher price. But at this price there are few, if any buyers, willing to purchase all of the stock from sellers who are willing to sell at this level. The only way the speculator can compete with the other sellers is to lower his price until all the stock can be sold at a level that fills every demand to buy. Depending on how erroneous his original price was he may break even or suffer a loss. Repeated losses will deplete the speculator’s funds until he has no wherewithal to speculate further and he is prevented from causing any more distorting activity on the market.

A final benefit is similar to that of the service that the speculator in location provides the orange grower – by finding a market for the product the latter is relieved of the risk and burden of having to do so and can concentrate on farming the product. Similar concerns face those who sell goods with a length of production that is relatively long and which may in and of itself be fraught with uncertainty. Once again crops are a good example. The farmer has to begin production and incur expenditure on factors in the spring whereas he will not reap the harvest and make an income until six to nine months later, during which any number of intervening events could occur that will affect the amount and quality of the final good. In steps the speculator who will, say, at the start of the growing season offer a definite price to the farmer for his whole crop, regardless of how it turns out at the end of the harvest. The speculator, of course, believes that the final crop will be of a quality and quantity that will enable him to earn a profit on what he paid to the farmer. The farmer, in turn, is willing to forego this profit so that he can purchase factors of production and begin work safely with the knowledge that the costs will be covered by a fixed amount of revenue in the future. Hence the risk of future prices is transferred from the farmer to the speculator.

Financial Traders

The financial trader is the speculator in time par excellence. He will buy financial securities that are claims upon real assets, withdraw them from circulation and sell them again for a higher price. Everything essential that needs to be known about this type of individual has been covered in the previous discussion. Nevertheless as the financial speculator in particular is the least understood and most vilified of all market participants some additional elaboration would be beneficial.

The consumer, as discussed above, bases his buying decisions upon whether the object of his purchase gives him greater satisfaction that the sum of money with which he parts for it. His gain is a psychic profit, one that cannot be measured or demonstrated but one that is, in his own mind, either satisfied greatly, somewhat or not at all. It follows therefore that his buying decision is dependent upon the quality of the good that he buys – if it is food it needs to have a nutritional value and taste the benefit of which exceeds the cost that was paid for it. But what of the person who sells it to him? If you are a fishmonger is it your preoccupation (aside from providing advice and recommendations or from utilising a degree of empathy with your customers) that salmon is delicious and nutritious and will provide a great deal of benefit if consumed? Or are you more concerned with the fact that consumers are willing to buy it at the price you offer and, in order to meet this demand, are you not concentrating on where you can source it at the lowest possible cost? A café owner doesn’t care whether coffee is good, bad, or ugly nor does a carpenter care about whether tables and chairs are nice to sit on; indeed both may utterly abhor the products that they produce. The focus of their operations is to recognise that consumers demand these things and they meet these demands by purchasing the factors of their production at the lowest possible cost, raising the price for these factors and hence choking off their diversion to less urgent desires of the consumers. What emerges therefore is a symbiotic relationship where the desire to earn profits on the part of the trader is harmonised with the desire of the consumer to acquire a good that will satisfy him.

If we turn, however, to the financial markets the same relationship is present between what we might call pure financial traders and investors. The latter is inherently concerned with whether the capital goods which he purchases will best serve the needs of consumers. If he must decide whether to invest in either companies A, B or C he must determine which of them (if any) is utilising (or will utilise) its assets in the best possible way in order to fulfil the demand of its customers. Even though, therefore, the investor is, like all market participants, a speculator in supply and demand and ultimately derives his entrepreneurial profit from imbalances between the two, there is an inherently qualitative dimension to his operation, similar to that of the consumer himself.

The market capitalisation of a company represents the discounted value of the company’s future profits – that is the present value of all of the future profits, necessarily discounted because a good available today is of higher value than the same good available at some point in the future. If you were to buy a whole company what you have really bought and what you are really paying for is the entire future profits of the company discounted to reflect the fact that you cannot enjoy these profits today but must wait for their generation at some future date.

However, the medium of such investment activity is normally financial securities – stocks and bonds being the most obvious and prolific – which are merely ways of scattering the ownership of a company across many different investors, each of whom owns a portion of the company’s future profits4. However these securities are themselves traded on an independent market and markets, as we know, are formed by the demand of buyers and the supply of sellers. There is, therefore, a supply and demand for ownership of these “pieces” of companies. This supply and demand is driven by investors and their views of whether a particular company will best serve the needs of consumers. It follows, therefore, that if a great number of investors believe that a company will be particularly illustrious and successful in performing this function the demand for its securities will be very high relative to their supply. If however, the investors believe the contrary – that the company is wasteful and has little or no prospect of earning a profit – there will be an eager rush to sell its shares and hence demand will be very low relative to supply. This is what, proximately, causes some share prices to be “high” and others “low” – the opinion of investors of whether the company concerned will generate future profits. Notice that this market operates entirely independently of the operations of the company itself; although the share price should, theoretically, follow the success of the company, they can and do diverge because investors change their minds as to the ability of the company to generate future profits. All this proves is that the investment operation is speculative – that it is looking forward to a future state that is uncertain and that this future state may turn out very differently from that which was hypothesised5.

There is, therefore, an investors’ market where people will buy not consumer goods like meat, bread or coffee but securities in companies. But this market operates just like the consumers’ market and it is wholly based on the supply and demand for the products that are traded. If coffee is suddenly demanded very highly then in step the speculators – caring not of the reasons for the consumers’ desires – who buy, and hence bid up the prices of, the factors of coffee production to ensure that less urgent needs are choked off from their use in order to ensure that they can be devoted to this very pressing need of the consumers that has emerged. But exactly the same happens on the market for securities. In just the same way that consumer demand for coffee might rise because they believe it to be delicious and nutritious, so too at any one time investors might increase their demand for shares of Company A on the belief that A has a strong prospect of earning future profits.

In, therefore, steps our financial speculator. In just the same way as the speculator in consumer products has to speculate on the demand and supply of these products, so too does the financial speculator speculate on the demand and supply – of the investors – for financial securities. In just the same way that the café cares not for the underlying qualities of coffee but only for the fact that it is in heavy demand, so too does the financial speculator care little for the qualitative prospects of the company from which the security is derived to earn future profits; he cares simply for the security’s supply and demand driven by investors. He will buy the security if he believes that, at this price level, demand for the security outstrips supply leading to an inevitable price rise; in other words, if investors who believe that the company will generate good future profits outnumber those investors who do not. He will sell the security when it reaches a price level where supply and demand are in equilibrium, or he will short sell if he believes that the supply of the security is in excess of its demand, i.e. if investors who believe the company will generate good future profits are outnumbered by those who do not.

It follows, therefore, that the majority of investors may be totally erroneous as to their opinions of the company; they may all want to buy a complete turkey of a company in the mistaken belief that it will be handsomely profitable, or, alternatively, they may sell the golden goose. The financial speculator cares not about whether these companies really have an underlying ability or lack thereof to generate future profits; his focus is entirely on whether the investors believe that they do and the consequential supply and demand that is generated for the securities6.

What economic benefits does such a speculator achieve? More or less they are identical to those of all other speculators. If the speculator predicts that demand for a security will be very high then not all of the investors who wish to buy can do so at the current price. The speculator’s additional buying will therefore cause a price rise that occurs sooner than it would otherwise have done so. In the same way that bidding up the factors of production diverts their use from less urgent needs, so too will the financial speculator begin to choke off demand from incompetents – not merely dabblers and gamblers or those with insufficient funds to purchase at the higher price but also those who are less certain or have been less scrupulous in forming their belief that the company is a worthwhile investment. The rise in price therefore reserves the supply of the security for the investors whose belief in the company’s prospects to earn returns is so strong and committed that they believe that even a purchase at this higher price is justified and will be covered by these future returns. It is to these people whom the speculator will sell. Conversely, when the speculator believes that supply of a security is in excess of demand – i.e. that the majority of investors believe that the company will not, at this security price, earn a future profit that justifies it – he will short sell it. As not all willing sellers can sell at this high price due to the lack of demand, the speculator’s actions in driving down the price will again choke off the less competent sellers – those who are less certain or have been less scrupulous in forming their belief that the company is a turkey – and the resulting fall in price to where demand is higher means that investors whose belief in the lack of the company’s prospects to earn returns is strong can now find a demand to sell to. It is from these people whom the speculator will buy to cover his short sale and, indeed, his aim – if he is to achieve the highest profit – is to buy from the very last of these investors, when the price movement is necessarily at the lowest it will go.

In sum, therefore, the financial speculator provides the committed investor, the one most dedicated to directing resources to where they are most urgently desired by the consumers, a supply of securities when the latter wishes to buy and a demand for them when he wishes to sell. There is, therefore, no substantive difference between the relationship of a shop with a customer and a financial speculator with an investor. It is merely that the service of the financial speculator, by ensuring that security prices most quickly reflect the underlying supply and demand, is not to directly channel resources to where they are most urgently needed but to facilitate the ability of the investors to do so.

It should be clear that the most lucrative investment operation is one that takes note of this speculative ability. For if one wishes to make the highest profit it pays to combine the two operations – by a) finding those companies that will best meet the needs of consumers and generate the highest profits, and b) whose securities are trading at a price where demand is far in excess of supply and hence are due for an inevitable price rise. It is for this reason that the famous philosophy of value investing – buying the most profitable companies at prices below that at which the investor believes represents their discounted profit stream – is so successful. Indeed, it is analogous to a consumer being able to buy at wholesale rather than retail prices – you are buying the same value but at a lower price hence the differential between the price and your reward is greater. As the first chapter to one introduction to value investing is titled, “Buy Stocks like Steaks…On Sale”7.

Charting, “Gambling” and Asset Bubbles

Let us conclude by laying to rest some additional myths associated with the financial trader. The speculator’s primary tool of price charts and its associated array of mathematical studies that are derivatives of price (used in methods that are collectively known as “technical analysis”) lead the casual observer to declare that all speculators do is follow a few patterns or look at a few studies and then repeat this over and over in order to rake in huge and “unjust” profits. But to assume this is to make the cardinal error of treating human activity like that of unconscious matter, that when any pattern or mathematical progression repeats it signifies a buy or sell signal that, unfailingly, will produce profits. Such nonsense detracts from the central task of the speculator, one that has been stressed over and over in the above – to find imbalances in the relationship between supply and demand. All he is doing, just like any other speculator, is finding the prices where supply and demand are in the largest disequilibrium except that he finds these areas by interpreting price charts. There is nothing technical or mathematical about this process; it is, rather, an entrepreneurial skill just like any other. Every profitable trader knows that there is not a single technical or mathematical study that, taken alone, will yield consistent profitable trading activity; indeed it is the fastest way to run down a trading account. Rather, the speculator learns what supply and demand imbalances tend to look like on a price chart and he trades only in these areas. But he knows that human action is not uniform and repetitive and he does not expect every instance of his analysis to provide the same result. Rather, he condenses his interpretative techniques to a handful of rules that he applies with a probabilistic approach to discovering where supply and demand are most in disequilibrium, risking a small percentage of his funds by stopping out of a trade in cases where he is wrong. The most skilled traders can keep such losses to a minimum to the extent that they simply become a cost of doing business; indeed with proper risk-management skills that ensure his losses are small and his profitable trades are large his interpretative methods may even allow him to make losses on more occasions than he makes profits. But regardless of his precise win/loss ratio recognition of the fact that a trading method does not work one-hundred percent of the time (a point on which all successful traders will agree) proves that there is nothing about trading from charts that can be scientifically or quantatively determined. The only science is in the fact that disequilibrium in supply and demand causes prices to rise or fall; interpreting where these points lie on a price chart is a rare, entrepreneurial skill.

Nor can it be said that financial traders are “gamblers”, that is that their returns are based on pure luck. The point of this essay has been to demonstrate that all market participants are speculators, they all, fundamentally, are doing the same thing regardless of their specific methods and preoccupations, and the economic effects of their actions are always the same. There is, therefore, no way in principle to distinguish one type of speculator from another. If a financial trader is a gambler on rising or falling prices then so is every business, every shop, every carpenter, and every plumber in the world. But even if financial traders or any speculators were simply gamblers then what harm would it do? Every speculator, as we have noted, must one day sell after he has bought. He is not a producer of original supply or final demand, rather he greases the market towards prices where the original suppliers and final demanders are in equilibrium. If he is successful in doing this he sells for a profit; if he is not then he sells for a loss. If the former then he has aided economic efficiency by moving supply and demand towards its equilibrium price, whatever his methods. Consequently he is trusted with more funds on which to make larger and more important speculations in the future. If he loses then it is the opposite – he has harmed discovery of the equilibrium price, but his resources for doing so are limited. If he keeps making losses then very quickly the market will wipe him out and his means for causing ill economic effects are curtailed. However if these losses happen through gambling then the situation is just like that of any speculator who applies faulty methods, whether they are laziness, sloppiness or simply a lack of entrepreneurial talent. There is no way to separate a gambling speculator from one that is simply bad.

Finally, let us consider wild speculative bubbles that, during boom years, inflate away like an aphrodisiac balloon until they finally pop, ushering in a recession or depression following a crash in prices. This is not the place to discuss at length the cause of the business cycle by artificial credit stimulation. But if such artificial stimulation distorts the underlying fundamentals of the economy – by making longer and more roundabout production processes appear more attractive and diverting resources unsustainably into capital projects – then this is not the fault of the speculator. Remember that every speculator is always in the position of having to sell after he buys. He cannot, therefore, affect the overall or average price level of the speculative good. In buying capital goods at the start of the boom, the very ones that he knows will be sucked up by all the freshly created and loaned money that is emerging from the artificially low interest rate environment, he merely moves prices quicker to where they are already heading as a result of all this newly printed money. The boom therefore happens quicker, but it is only in response to the anticipated demand that has been falsely stimulated by credit creation. The same happens at the bust phase – by selling or short selling the speculator simply lays bare the fact that demand and supply, at such inflated prices, cannot continue to be in equilibrium in the absence of continued credit expansion. His action at the peak of the market and on its slide down liquidates the boom’s malinvestments quicker and, uninterrupted, provides a painful but much speedier recovery to a sound and stable economy than otherwise would be the case. Speculation exists to serve the direction of supply and demand in the economy whatever causes this supply and demand to occur on the part of market participants. If the directions of supply and demand are distorted by destructive interventions then their consequences are not the fault of the speculator. Proper blame should be laid at the door of the easy credit policy which still, regardless of the continuing economic malaise since 2008, is the favourite of governments and central banks everywhere.

Conclusion

In sum therefore, it may be said that:

All human actions are speculative and therefore everyone is a speculator;

That all consumer choices are speculations;

That all market participation – buying and selling – is speculative;

That speculative activities are beneficial to channelling the scarce resources of the Earth to their most urgent needs and uses by harmonising supply and demand;

That it is not possible to distinguish, in principle, between different speculative activities on the market; and that, further, differences between types of speculator usually centre on the fact that a lack of physical change to a good is falsely regarded as a lack of added value;

That common myths regarding the nature and alleged destructiveness of financial trading in particular are entirely false.

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1 We might also point out that the higher prices of the factors will also be preceded by speculative action for them as well, and investment will also be drawn towards increasing the supply of these factors that is now justified by their increased price. Hence their factors also will increase in price, and so on and so forth right back through the chain of production until prices for all of the factors and their respective finished product approach equilibrium.

2 If this equilibrium is reached oranges will still trade at a premium in London because of these costs.

3 For the avoidance of doubt we are not referring here to the premium placed on present goods vs future goods as a result of the law of time preference; we are discussing here real changes in the supply and demand for a good.

4 Shareholders and bondholders fulfil the same economic function as each other – they both advance investment funds to the company. The difference is that they do so merely on different legal terms and acquire different rights through the respective relationships.

5 Earnings announcements are typical examples of where the share price diverges from the company’s ability to earn future profits. If earnings are good the share prices normally rocket on the news whereas if the are bad they plummet. But today’s earnings have nothing to do with tomorrow’s. If today’s are bad it might be that the company still has the ability to pull itself together and deliver a result tomorrow; or it might really be a turkey and still continue to lose money. If, on the other hand, today’s results are good this might be the best that it ever gets and tomorrow will only generate lower profits or even losses; or it might just be the start of a long and prestigious career of generating truly handsome returns. All of these options are possible yet nearly always investors react as if good news today is good for tomorrow and bad news today is bad for tomorrow.

6 These facts should put an end forever to so-called efficient market hypothesis (EMH). The hypothesis is based upon a misunderstanding of why markets are said to be “efficient”, a term itself that is vague and stifles clarity. Markets are “efficient” because they harmonise the supply and demand for goods through the price mechanism, in other words goods are directed to where they are most highly sought and, a fortiori, their most highly valued ends. But the efficiency of markets has nothing to do with the underlying valuations that drive this supply and demand. These are products of the human mind, the result of desires and choices, and the notion that prices respond “efficiently” to publicly available information suggests that the impact of this information upon such human choice and desire is uniform, predictable and quantifiable. The theory’s weakness is similar to that of a strict adherence to the quantity theory of money in attempting to explain how increases of the supply of money affect the so-called “price level”. Further, the entire reason why profits are earned in an economy is because future valuations are not known, nor are they available in publicly disseminated information; it is, rather, the task of entrepreneurs to bear the risk of predicting them through their understanding of their customers’ sentiments. A million investors, acting on all of the publicly available “information”, may dump the stock of a company that, tomorrow, will earn sky-high profits. The one investor who goes against this grain and buys all of the sold stock is the person who reaps the “excess” reward that EMH states is impossible or at least unlikely.

The author responded to a lengthy article, posted online, that advocated strongly social democracy. Unfortunately the original link has broken but the text below quotes the article in its entirety, interjected by responses.

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“Democracy is a form of government in which all citizens take part. It is government of the people, by the people, and for the people. Socialism is where we all put our resources together and work for the common good of us all and not just for our own benefit. In this sense, we are sharing the wealth within society.”

Socialism is the abolition of private property in the means of production, i.e. no individual owns the physical entity of or is entitled to the capital value of any capital or producer good. Once this has been accomplished there remains the problem of how to direct these resources to the most highly valued ends. Contrary to the tacit assumption of many socialist thinkers there is no separate, conscious entity who feels and knows what the “common good” is; there are only individual humans who each value different ends independently; they may agree, in some cases, on what are valuable ends but they still hold these values as individuals and they are liable to change. Further, there will be disagreement on how these ends are to be achieved and precisely which of the scarce means are to be allocated to them. So how is a) the most valuable ends and b) the most suitable means for those ends to be determined under Socialism? How is disagreement on these matters to be reconciled?

All valuable ends are confronted by the same problem – scarcity of the means of production. Hence the economic problem is how to direct scarce means to the most highly valued ends. You can advocate that this can be done either through socialised property or private property but you cannot argue in favour of both together – they are entirely different solutions to the same problem. If you start from the premise that “certain industries” may be socialised you are already advocating that at least some of the factors of production should be allocated to these industries, but this can only be arbitrary. How do you know? And if you know how do you know which factors should be allocated and in which proportion? How do you compare one set of allocations with another set?

A system of private property in the means of production answers this through pricing, profit and loss. For private property gives way to exchange which creates supply and demand which produces prices which produces profit and loss. Hence costs and revenue can be reduced to a single common denominator, the unit of exchange (money), that allows resource allocation to be compared across the entire economy.

In the absence of private property, however, there can be no exchange. There are therefore no prices in the factor of production and no profit and loss. How are the factors of production to be compared? How is the electorate or its democratically elected caretakers of the means of production to compare the cost of 5 tonnes of steel, 3 tonnes of wood, 40 labour hours, 500 sheets of paper, 6 billboards of advertising, 30 hours of telephone calls if it cannot reduce these inputs to a common denominator?

“Of course when people hear that term, “Share the wealth” they start screaming, “OMG you want to rob from the rich and give it all to the poor!” But that is NOT what Democratic Socialism means. To a Democratic Socialist, sharing the wealth means pooling tax money together to design social programs that benefit ALL citizens of that country, city, state, etc.”

If a person is wealthy in a pure private property society (where trade is entirely voluntary) it is because he has produced a comparatively high quantity of goods that other individuals are willing to purchase. A poorer person has produced comparatively less. The wealth of the rich can only grow if they abstain from consumption of their income and invest it in order to increase the number of goods they can produce. Most of the wealth of the rich consists of, or is derived from, real valuable assets – factories, commodities, plant, shops and inventories. They continue to be rich because these assets are productive – other people are willing to exchange them for another valued good, i.e. money. If they cease to be productive their capital value will decline and so will the wealth of the owner.

If the amount of pooled wealth available for government programs is to increase these real resources have to be liquidated from their current uses and the workers have to be laid off and transferred to Government employment. For every resource that is consumed in a government program that is one resource less that can be used for something else. By which method do you calculate whether the resources are being put to their most valuable ends in the hands of private entrepreneurs or in government programs?

“The fire and police departments are both excellent examples of Democratic Socialism in America. Rather than leaving each individual responsible for protecting their own home from fire, everyone pools their money together, through taxes, to maintain a fire and police department. It’s operated under a non-profit status, and yes, your tax dollars pay for putting out other people’s fires. It would almost seem absurd to think of some corporation profiting from putting out fires. But it’s more efficient and far less expensive to have government run fire departments funded by tax dollars.”

This is no different from insurance. Individuals pool their premiums together with a private provider in order to provide the resources for extinguishing fires in an emergency and/or compensating the unfortunate victims of fire damage. The only difference is that each individual can choose whether to pool his premiums with one particular provider or not (or at all). The insurer therefore has to act in a way that will retain its customer base, one of which is to keep premiums lower than those of its competitors. The primary method of accomplishing this is to minimise the amount that has to be paid out in compensation and the only way to do this is to prevent and control fires as much as possible. The insurer may, therefore, specify that your home be fitted with some basic fire-fighting equipment such as fire extinguishers or fire blankets and that all of your equipment is electrically tested, for example. If the cost of this is less than the saving you make on a lower premium then you are likely to do this. They may charge higher premiums in cases where flammable substances are stored on a property, or refuse to insure you altogether because the risk would be too great, thus discouraging the accumulation of dangerous materials. The result of this is that each person pays according to the amount of risk he is willing to bear and everyone, consumer and insurer, is equally interested in taking steps to minimise the number of fires as much as possible.

If a fire does start, however, the longer they burn the more the insurer has to pay in compensation to a covered individual. They are therefore likely to respond with the utmost urgency with their own, privately owned, fire fighting equipment or privately contracted fire fighting supplier in order to minimise the amount of damage.

All of these incentives are lost when fire-fighting is managed by the Government. The Government does not need to be concerned about losing your premium to a competitor – you have to pay it in taxes or it will incarcerate you regardless. Hence it is less bothered about minimising the amount of damage. Fewer homes will therefore be installed with preventive equipment and less electrical testing will take place. There will therefore be more fires. Further the tax paid towards fire-fighting services is not adjusted to your individual level of risk; rather it is determined by your income. There is therefore less incentive to avoid the accumulation of risks that contribute towards fire. Every preventative measure you take is an extra cost but there is now no added benefit – you still have to pay the tax and you are still entitled to the same service as everyone else. The result will be less prevention and more fires, more destruction of property and consequently less overall societal wealth.

And finally, once a fire starts, the Government is not going to lose any money if your house burns. Even if it has to pay you compensation the Government will not go out of business if it has to pay too much, unlike a private firm. The Government-employed fire-fighters know that, regardless of what happens to your house, they will, in principle, still be employed and paid tomorrow regardless of the cost to the Government of compensating you for your house. This is not to suggest that Government fire-fighting will always be slow, shoddy and negligent. But given these facts what is the likelihood that a Government fire service will respond more efficiently to a case of fire than a private fire service?

This is a typical case of Government having carried out a particular function for so long that everyone forgets what it looks like when it is carried out privately. Yet the above should demonstrate how it would most likely be done and to a higher degree of efficiency than by the Government.

“Similarly, public education is another social program in the USA. It benefits all of us to have a taxpayer supported, publicly run education system. Unfortunately, in America, the public education system ends with high school. Most of Europe now provides low cost or free college education for their citizens. This is because their citizens understand that an educated society is a safer, more productive and more prosperous society. Living in such a society, everyone benefits from public education.”

No one denies that education is a beneficial and indeed a good and beautiful thing. But for every resource spent on education there is one less resource to be spent on something else. How do you know that education is the most productive use for these resources?

We could devote the entire productivity of the world to a huge and glorious education system where everyone pops out as smart as Einstein. But there would be no cars, no shops, no food, no computers, no houses, no offices, no factories etc. because all resources are devoted to the education system.

The problem faced by an economic system is not to determine what is valuable in the abstract – it is how to direct the scarce means to their most highly valued ends before all others.

“When an American graduates from college, they usually hold burdensome debt in the form of student loans that may take 10 to even 30 years to pay off. Instead of being able to start a business or invest in their career, the college graduate has to send off monthly payments for years on end. On the other hand, a new college graduate from a European country begins without the burdensome debt that an American is forced to take on. The young man or woman is freer to start up businesses, take an economic risk on a new venture, or invest more money in the economy, instead of spending their money paying off student loans to for-profit financial institutions. Of course this does not benefit wealthy corporations, but it does greatly benefit everyone in that society.”

But the cost has to be paid by someone. If the graduate has to pay for his own education then yes he has less money to “start up businesses, take an economic risk on a new venture, or invest more money in the economy”. But if everyone else has to pay for his education through taxes then everyone else has that little bit less to do all of those wonderful things. The graduate has only gained what everyone else has lost.

“EXAMPLE American style capitalistic program for college: If you pay (average) $20,000 annually for four years of college, that will total $80,000 + interest for student loans. The interest you would owe could easily total or exceed the $80,000 you originally borrowed, which means your degree could cost in excess of $100,000.”

If the cost of $80 000 tuition is paid back by the graduate without the interest of, say, $20 000 then that is $20 000 less that can be loaned to another student. There will therefore be fewer funds available to loan to more students for their education. Fewer students will therefore be educated. That is presumably not the intended outcome of this author. Governments, of course, could simply raise taxes to make up the shortfall. But again, all this will mean is that what the graduate has gained the taxpayer has lost.

“EXAMPLE European style social program for college: Your college classes are paid for through government taxes. When you graduate from that college and begin your career, you also start paying an extra tax for fellow citizens to attend college. Question – You might be thinking how is that fair? If you’re no longer attending college, why would you want to help everyone else pay for their college degree? Answer – Every working citizen pays a tax that is equivalent to say, $20 monthly. If you work for 40 years and then retire, you will have paid $9,600 into the Social college program. So you could say that your degree ends up costing only $9,600. When everyone pools their money together and the program is non-profit, the price goes down tremendously. This allows you to keep more of your hard earned cash!”

The cost of $20 monthly is arbitrary and no proof of this being the real cost under such a system is offered. The conclusion that “the price goes down tremendously” is, therefore, a non-sequitur. If anything, the cost of education is likely to go up as relieving every individual of the cost of his tuition will cause an increase in demand which causes prices to rise.

This is the reason, in the UK, for the recent “outrages” over higher education tuition fees. Government sanctioned loans systems artificially stimulate demand while the Government also caps the number of students, hence leading to a reduction in supply. Increasing demand and suppressed supply equals spiralling costs.

It is therefore Government interference with the higher education system and not private finance that makes bearing the costs of higher education so intolerable to graduates.

“Health care is another example: If your employer does not provide health insurance, you must purchase a policy independently. The cost will be thousands of dollars annually, in addition to deductible and co-pays. In Holland, an individual will pay around $35 monthly, period. Everyone pays into the system and this helps reduce the price for everyone, so they get to keep more of their hard earned cash.”

Healthcare premiums are so expensive in the US precisely because of Government interference in the insurance industry (and the only reason that insurance is the preferred method of funding healthcare is an anomaly that originates in The Great Depression). If Governments legislate so as to compel a provider to insure risks which are perceived by the latter as higher and more costly then the latter is forced to take on the burden of paying more than it would like when these risky events transpire (an almost guaranteed certainty if the insured event is something over which the policyholder has control. This is simply compensating individuals for their deliberate actions). Costs, therefore, rise.

Socialised healthcare under Medicare and Medicaid under which the healthcare consumption of an individual is divorced from its cost to the individual, the ease of malpractice suits, and lengthy and bureaucratic drug approval processes mandated by the FDA all contribute to the rise in healthcare costs in the US. None of these are phenomena of the free market.

Holland also operates on an insurance-led basis. One should investigate whether the lower cost allegedly associated with this is because of less and not more Government involvement.

“In the United States we are told and frequently reminded that anything run by the government is bad and that everything should be operated by for-profit companies.”

This is a list of Federal Government departments and agencies. Just a brief glance will reveal Government involvement in commerce, transport, housing, education, broadcasting, agriculture, labour, security, energy, healthcare, environment and engineering. Even if America is “frequently reminded” by somebody “that anything run by the Government is bad” no person can look sensibly at this list and conclude that Government does not already control or regulate vast areas of the US economy.

“Of course, with for-profit entities the cost to the consumer is much higher because they have corporate executives who expect compensation packages of tens of millions of dollars and shareholders who expect to be paid dividends, and so on.”

Executive compensation cannot determine market prices of consumer goods. Every good purchased by you is evaluated on its merits alone, not on the costs that went into producing it. If you deem the merchant’s asking price to be less valuable to you than the utility you will gain from the good then you will make the purchase. Otherwise, you will not make the purchase. It is therefore because an entity’s goods are so highly valued and consequently sell so well that companies are willing to pay more to hire the best employees. Not so if their sales are less successful.

Profit (and loss) is revenue minus costs. In order to make a profit you must increase your revenue as much as possible but what is forgotten is that you must reduce your costs also. Employee compensation is a cost and the higher it is in relation to revenue the lower the profit of the entity will be; the lower the profit, the less it will be able to invest in growth and the sooner it is more likely to stumble in meeting the needs of consumers which is the first step to insolvency.

In 2011, total executive compensation at Tesco plc was £21.7m against a turnover £60.9bn, approximately 0.0356%. Even if executive compensation did drive up consumer prices one has to wonder how such a small percentage could make much of a difference.

Finally, regarding very large corporations one might wish to investigate the effects of monopoly and regulatory privilege granted by Government and the effects of Government–granted limited liability in generating a preference for the large, publically-traded entity before implying that these beasts are creations of the pure pricing, profit and loss system.

“This (and more) pushes up the price of everything, with much more money going to the already rich and powerful, which in turn, leaves the middle class with less spending money and creates greater class separation. This economic framework makes it much more difficult for average Joes to ‘lift themselves up by their bootstraps’ and raise themselves to a higher economic standing.”

You cannot leave the general population with less spending money and push up the price of everything simultaneously. If the population was left with less money then it would have less with which to bid for goods and services. The latter would therefore remain unsold until prices were dropped. If prices were dropped, profits for vendors would drop. If profits drop then costs have to be cut. One of those costs is executive compensation.

If a firm, however, is able to continue to raise its prices without affecting sales and this increases profit margins beyond that experienced in other industries, resources are diverted away from the less profitable industries and into the profitable both by the existing entity and by new competition. Supply is therefore increased and prices consequently decrease.

It is therefore very difficult for an entity to raise its prices to increase profits without a) choking off sales or b) attracting competing investment.

The most effective way for the latter to be avoided is for the entity to induce the Government to regulate the industry. Compulsory licensing, planning permission, Government imposed trading standards, health and safety standards, employment regulation, etc. all serve to deter competition. For every extra regulation that must be complied with is an extra cost that a new competitor must meet and, by virtue of its status as a start-up, must consist of a larger portion of its costs that those of an incumbent provider. There is therefore a tendency for larger firms to become entrenched and for the “Average Joes” to be unable to “lift themselves by their bootstraps” – all because of Government intervention.

“So next time you hear the word “socialism” and “spreading the wealth” in the same breath, understand that this is a serious misconception.”

That is precisely what the effect of socialism is. In a capitalist society wealth accumulates to each person according to his productivity. If another system is adopted then the wealth must be distributed in a different way with a different result; otherwise implementing socialism would be pointless. Hence socialist writers devoted part of their theory to the problem of distribution of goods in a socialist society, i.e. to “spreading the wealth”.

“Social programs require tax money and your taxes may be higher.”

Correct.

“But as you can see everyone benefits because other costs go down and, in the long run, you get to keep more of your hard earned cash!”

What has been demonstrated, in fact, is that costs rise under socialism. If an individual does not have to pay for his consumption, all else being equal he consumes more. Hence demand rises and so do costs.

“Democratic Socialism does NOT mean taking from the rich and giving to the poor.”

It means taking from the productive to fund the unproductive. This can be the only logical outcome of a system other than private property, where the fruit of production accrues to the producer.

“It works to benefit everyone so the rich can no longer take advantage of the poor and middle class.”

It benefits the unproductive ahead of the productive. The unproductive are able to take advantage of the productive. Productivity therefore becomes less valuable and decreases whereas un-productivity becomes more attractive. Societal wealth therefore declines.

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POSTSCRIPT: The main error of the author of the original article (apart from providing blatant examples of Bastiat’s famous “broken window” fallacy) is the belief that a market economy provides benefits only for some whereas “democratic socialism” provides benefits for all. Precisely the opposite is true. Under the free market all exchanges are voluntary. If A exchanges a good with B then it must be because they each value what they receive more highly than what they give up. Both therefore benefit from the transaction and we can say that social utility is increased. A system of “democratic socialism” however would necessarily involve violently enforced transactions (taxes). If an individual has to be coerced into a transaction then it necessarily means that he values abstaining from the transaction more than entering it (otherwise he would have entered it voluntarily). The recipients of Government spending may gain (as does the Government itself) but here, in contrast to a market economy, some have gained at the expense of others. As we cannot make interpersonal utility comparisons (i.e. we cannot “measure” utility) it is impossible to say that the gain to one is greater than the loss to another. But even if this wasn’t true the fact remains that the coerced individuals would have gained greater utility from not being taxed and to them the transaction is very much a loss; hence a system of “democratic socialism” does not provide “benefits for all”.